Implied volatility

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Implied volatility is a measure of traders perceived risk in the underlying asset of an option.

Implied volatility is different from volatility, in the sense that implied volatility represents expectations about future fluctuations while volatility is observed by looking at past data.

Volatility expectations, or implied volatility, is deduced from option prices (both call and put) on an underlying security -- since these expectations are reflected in market prices of the option. Higher fluctuation expectations mean that the option has a greater probability of ending in the money, and thus the option commands a higher price and vice versa. By inputting the option price, along with other variables such as maturity, interest rate, strike price and underlying security price, in a pricing model (e.g. Black-Scholes) it is possible to derive an estimate of the investor's expectation of future volatility.

To derive a fair price for a particular option, the historical volatility is used. Often, though, the price that an option trades for on an exchange is different than the theoretical price, and the volatility that is used to derive the exchange price is referred to as implied volatility.

Implied volatility exhibits a skew since it is higher on options below the current price of the underlying security, than those above the current price of the underlying.

In practice, Implied Volatility is also the variable market makers play around with in order to make a higher profit on options that are suddenly in demand. This variability does not allow Black Scholes model to calculate implied volatility accurately.

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