Many of us find ourselves in a predicament when deciding which move to make regarding any investment. It’s the fear of the unknown and understandably so. That uncertainty might hinder you from making an excellent trade that will set you off on a path to making good cash.
In which case, you might find yourself wondering what IV is and how it works. Luckily, Implied Volatility (IV) will alleviate your worries and help you make much-informed decisions. IV is a metric that estimates the degree of probability of change of a particular security’s price in specified periodic times.
What you should know
Implied value gives you the probability of the price change of a stock option. However, it does not predict what the prices will be. When you find that the IV is 25%, you should presume that the current price will change to accommodate the price’s 25% increase or decrease in the indicated time.
It simply means that considering the market factors, the current price is likely to fluctuate (on the high or low end) to that degree within the specified time.
What’s more, the IV of a Stock Option is greatly affected by the demand and supply of the product or service in question. When there is a high demand for a particular product, then it is expected that the prices will rise.
Alternatively, when there is a larger supply of the product/service than the demand, the price will tend to decrease. In either case, the IV will increase significantly as there is a higher degree of uncertainty about where the prices will eventually fall.
Further, the time associated with a Stock Option also influences the IV. It is prudent to argue that shorter times of a Stock Option will have a small IV as it is much easier to assess the immediate likelihood of an event happening as compared to much more extended periods.
A lot can happen in a lengthy period, which affects what to expect in the long run.
It is also paramount that you do not confuse implied volatility with historical volatility (statistical volatility). While historical volatility relies on past events, IV is forward-oriented and does not consider how the price fluctuated in the past.
Instead, it relies on the present circumstance surrounding the Stock Option and the likelihood of the event deviating due to specified market factors.
Taking this principle into account, critical financial experts such as tastytrade argue that when the uncertainty of a Stock Option increases, so will the IV in what is referred to as an ‘IV expansion.’ The opposite holds, for when there is less uncertainty about the Stock Option prices, the IV will decrease, a phenomenon regarded as ‘IV Contraction.’
Takeaway
The Implied Volatility index is essential to any Stocks trader as it helps quantify the uncertainty of the market sentiment. Further, the IV also helps set the Stock Option prices, effectively helping you in your trading strategy.
Nonetheless, it would be best to take caution not to over-rely on the IV as it solely uses the prices to determine the outcome, and thus can be influenced dramatically by other unexpected factors.
