Implied Volatility
Implied volatility is the market's expectation of how much an asset's price will move over the life of an option, expressed as an annualized percentage. It is not observed directly but backed out of an option's market price using a pricing model such as Black-Scholes: the volatility input that makes the model's value equal the traded price is the implied volatility. Higher implied volatility means more expensive options.
Worked example
An option pricing model values a one-year at-the-money call on a $100 stock at $8 when volatility is set to 20%. Suppose the option actually trades in the market at $12. Plugging higher volatilities into the model, the price reaches $12 when volatility is set to roughly 30%. That 30% is the implied volatility — the market is pricing in a 50% larger expected move (30% ÷ 20% = 1.5) than the 20% assumption.
Why it matters
Implied volatility matters because it is the market's collective forecast of risk and the single biggest driver of an option's price beyond the underlying itself. Traders compare it with historical volatility to judge whether options look cheap or expensive. The common pitfall is mistaking it for a direction signal — high implied volatility says a big move is expected, but says nothing about whether the price will rise or fall.
Frequently asked questions
What is the difference between implied and historical volatility?
Historical (or realized) volatility measures how much the price actually moved in the past. Implied volatility is forward-looking, derived from current option prices, and reflects what the market expects to happen rather than what already did.
What does the VIX measure?
The VIX is an index of the implied volatility of S&P 500 options over the next 30 days. Often called the "fear gauge," it rises when investors expect larger market swings and falls when they expect calmer conditions.
Related terms: Black-Scholes Model, Option Greeks, Volatility