The term implied volatility refers to a measure that allows an investor to understand how much the market believes the price of a stock will move over time. Implied volatility is an important concept for investors in options to understand.
Also referred to as IV, implied volatility is an estimate of a security's future price movement. It does not provide the investor with insights into the direction of the security's price, only an estimate of the possible magnitude of its change. It's viewed by analysts as an estimate of a stock's probable trading range.
Implied volatility is a mathematical concept and it's often depicted using the Greek letter sigma [INSERT SIGMA SYMBOL HERE] since it's a measure of the data's standard deviation, which is the quantification of the variation in a set of data. Implied volatility is an especially important concept to individuals that invest in options. While IV is not a guarantee of price movement, it does reflect the market's perception of the stock's price volatility at a point in time.
In fact, implied volatility can change over time and is a function of factors such as market demand. As market demand for a security increases, the price of the security will increase as will implied volatility. As market demand for a security decreases, the price of the security will decrease and implied volatility will also increase. Time until expiration also affects implied volatility. Everything else being equal, an option with a shorter time to expiration will have lower implied volatility than an option with a longer time to expiration. Generally, the higher the implied volatility, the higher the premium paid for an option.
An individual is considering investing in Company ABC's common stock, but would like to better understand the market's expectation of its price movement in the next twelve months. Company ABC's stock is currently trading at $100 per share, with an implied volatility of 12%. Assuming a normal distribution of the data, one standard deviation movement in the price would be:
= $100 x 12%, or $12
One standard deviation represents a 68% probability of the data, which means there is a 68% chance Company ABC's stock will trade between $88 and $112. But what if the trader wanted to be more certain of the price range? Two standard deviations provide a 95% probability, so two standard deviations in price would be:
= $100 x 2 x 12%, or $24.
This information tells the trader there is a 95% chance Company ABC's stock will trade between $76 and $124 over the next twelve months. Using three standard deviations provides 99% certainty around the price. Keep in mind that IV is stated on an annualized basis. If the trader would like to understand the expectation of the stock in the next 30 days with 99% certainty, the calculation would be:
= $100 x 3 x (12% / 12), or $3
This tells the trader there is a 99% probability the price of Company ABC's stock will trade between $97 and $103 in the next 30 days.