What is Implied Volatility?

Implied Volatility (IV) refers to the implied magnitude of potential upward or downward movements in an underlying stock's price over a year. In other words, it is the annualised expected move in the underlying's price, adjusted for the duration to expiry. Derived from the Black-Scholes model, it is denoted as a percentage and takes the stock price, expiration, etc into consideration.

For example, stock ABC is currently trading at Rs. 100 per share and has an implied volatility of 20%. This means that the market expects its price to move between the range of Rs. 80 and Rs. 120 (20% lower and higher) over the next 12 months, with a 68.2% probability of accuracy.

Low IV implies that the market does not expect the stock price to deviate much from its current price over the next 12 months.
High IV implies that the market expects large deviations from the current stock price over the next 12 months.

A common misconception regarding IV is that it drives options prices. In reality, it is the other way around; changes in options prices allow us to find a new IV value after the change has already occurred.

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