How To Use Implied Volatility

by Linda Ray

Implied volatility and the methods you incorporate to determine it are tools you can use to gauge where and when to invest in various stocks. To determine the implied volatility at any one time, you must take into consideration the standard deviation, or historical performance of the stock. Taking into account past performance, you can use implied volatility to help you predict potential future activity.

Formula

Volatility typically is expressed in annual terms. There are a variety of mathematical equations you can utilize to gauge the amount of implied volatility you can expect from a certain option. One of the first algebraic formulas to assess implied volatility was the Black-Scholes Model, initially created in 1973 for European trading markets. The Black-Scholes equation forms the basis for most other formulas created since then to better serve the American markets and include the Binomial Option Pricing Model. The models incorporate variables such as the current stock price, the risk-free interest rate, date of expiration and the amount of dividends paid. The market analysts who prepare implied volatile statistics also take into consideration their own assessment of the market and the events that could affect price changes.

Effects

A number of circumstances can affect the implied volatility and can include new product announcements or government regulation rulings. When a company releases earnings, the implied volatility may rise or fall, depending on earnings expectations. Elections, extreme weather and mergers are events that could trigger implied volatility changes. Choosing to buy or sell based on implied volatility before an event takes place is much riskier than waiting until after the precipitating event and assessing the fallout.

Breaking It Down

Since implied volatility percentages are expressed in annual terms, you’ll need to break down the figure to determine the daily, weekly or monthly potential changes you could expect. For example, if a stock’s implied volatility is rated at 35 percent, you’ll need to multiply that figure proportionately to the square root of time. Since there are 252 market days in a year, you multiply 35 percent by the square root of 252, which equals an approximate 2.2 percent daily volatility. Two-thirds of the time, that particular stock will be up or down 2.2 percent on any given day.

Practicality

In practical terms, you can use implied volatility numbers to make decisions about your trading investments. The higher the implied volatility, the better chance you have of increasing your stock purchase value, while a lower implied volatility usually indicates your stock could remain stagnant. The real value of the prediction is that it can help you determine the amount of risk you’ll be taking with certain buys as well as the possible returns you may receive.

About the Author

Linda Ray is an award-winning journalist with more than 20 years reporting experience. She's covered business for newspapers and magazines, including the "Greenville News," "Success Magazine" and "American City Business Journals." Ray holds a journalism degree and teaches writing, career development and an FDIC course called "Money Smart."

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