In contrast, implied volatility (IV) is derived from an option’s price and shows what the market implies about the stock’s volatility in the future. Implied volatility is one of six inputs used in an options pricing model, but it’s the only one that is not directly observable in the market itself.
Implied volatility (IV) is one of the most important concepts for options traders to understand for two reasons. First, it shows how volatile the market might be in the future. Second, implied volatility can help you calculate probability. This is a critical component of options trading which may be helpful when trying to determine the likelihood of a stock reaching a specific price by a certain time. Keep in mind that whiles these reasons may assist you when making trading decisions; implied volatility does not provide a forecast with respect to market direction.
There are many different types of volatility, but options traders tend to focus on historical and implied volatility. Historical volatility is the annualized standard deviation of past stock price movements. It measures the daily price changes in the stock over the past year.
Since most option trading volume usually occurs in at-the-money (ATM) options, these are the contracts generally used to calculate IV. Once we know the price of the ATM options, we can use options pricing model and a little algebra to solve for the implied volatility.