Implied volatility refers to the estimated volatility of the price of a security. Implied volatility is generally inversely proportional to the stock price index of the market. This implies that the implied volatility decreases when the stock market is experiencing a bull and it increases when the stock market is experiencing a bear.
This happens because of the belief that the bearish stock markets are riskier than bullish stock markets. The concept of implied volatility is not only used to calculate the market factors like market price, expiration date, interest rate and strike price but is also used to measure the premium of an option. Implied volatility is calculated from the economic models like Black-Scholes Model.
In other words, it can also be said that the implied volatility of an option refers to the volatility that is connoted by the option market price depending on the pricing model of an option.
The volatility of an option actually gives the theoretical option value that is same as the current market price. The financial instruments that are not options can also have the implied volatility.
The implied volatility very often gives the measure of the relative value of the option. But it does not give the price of the option and this is because the option price depends directly on the underlying instrument price.
For the options that are included in the delta neutral portfolio, implied volatility plays as the most important factor in order to determine the option value. Because of the huge importance of the implied volatility, rather than the price, the options are generally cited in terms of volatility. This is mainly done by the professional traders.
The options that are based on the same underlying security but having different expiration time and strike value, will generally give dissimilar implied volatility. This happens because the volatility of the underlying security is variable and is dependent on various factors like underlying security’s price level, recent variance of the underlying security and the time passage.
Last Updated on : 1st July 2013