What Does Implied Volatility Tell You Regarding Stock Options?
Implied volatility is a forecasting tool used very often when trading stock options. A stock option is an instrument that allows investors to purchase or sell stock in the future, within a particular timeframe and at a particular amount according to the terms of the option. By purchasing this right to buy or sell future shares, investors can hedge their bets and earn extra profit by correctly gauging the response of the market in coming months. Implied volatility helps investors make important decisions during this process.
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Implied Volatility
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Implied volatility is a measurement of how much a stock can be expected to change based on current market activity. Past volatility is a study of how sharply prices for a particular type of stock have risen and fallen. When implied, this measurement is extended into the future. Analysts use the data available to create forecast limits on how much the stock may rise or fall based on probability. This only shows how sharp the change may be, not in which direction it may occur -- this is left to other types of forecasting and investor research.
Stock Option Factors
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Several different factors determine the price of stock options. For instance, the exercise price -- the price at which the investor can buy or sell the stock in the future -- determines the option price, as does the riskless rate of return, the maturity date, and other factors. Taken together, these factors are also used to determine the future volatility of stock prices. Analysts look at the terms being offered on a wide range of stock options and in turn use this information to create volatility indexes.
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Measuring Risk
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Investors care about stock volatility because it allows them to more accurately measure the risk of buying and using an option. If volatility is high, the investor knows that the returns of an option could be very high, but that the option might end up being a loss if the stock moves in the opposite of the expected direction. Likewise, low volatility tends to mean that stock options will not be able to create high returns, and investors should not be willing to pay high prices for them.
Keeping Up With the Market
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Implied volatility can be difficult to measure, especially when the market is moving fast. Sometimes option terms change so frequently that true volatility predictions are not possible except in retrospect, which is not as useful. At other times, the market can become one-sided with only buying or selling, in which case market makers often assess volatility and change it based on their own strategies, making volatility measurements somewhat contrived and not necessarily a fair measure of market activity.
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