Implied volatility

Implied volatility is the market's own priced-in estimate of future price swings. Nobody measures it directly: it follows from what people are willing to pay for options, that is, for insurance against large moves.

Ordinary volatility looks back: how much the price has moved so far. Implied volatility looks forward: how much the market expects it to move.

Where it comes from

An option gives the right to buy or sell an asset at a price agreed in advance. The bigger the swings the market expects, the more valuable that right and the dearer the option. So the option price can be turned around to show what volatility the market put into it. That is implied volatility.

For the main markets Cboe publishes it as an index:

How to read the number

The index is quoted as annual volatility in percent. For a shorter period, divide by the square root of time:

$$\sigma_{\text{period}} = \frac{IV}{\sqrt{N}}$$

IV is the index value in percent and N is the number of such periods in a year: 12 for a month, 252 for a trading day. The assumption behind it: swings in separate periods are independent of each other.

What to watch for

Implied volatility tends to be higher than what actually happens. Option sellers charge a premium for the risk. On the same day the VIX was 16.34, the S&P 500's realised volatility over the previous 21 days was only 10.52%. Models built on it therefore calibrate it against history first.

It says nothing about direction. A high VIX means the market expects big moves, not that it expects a fall, even though the two often coincide.

It is a price, not a forecast. It reflects fear and demand for insurance, not only a cool estimate.

Where you will see it

Our investment models use the VIX, VXN, GVZ and OVX as the main input for the volatility estimate over the next month. The formula and the calibration are in their method section.