Implied Volatility

Implied volatility (IV) is the market’s estimate of how much the price of an underlying will swing in the future. It isn’t measured directly. Instead, it’s worked out backwards from the premium that traders are actually paying for an option, using an option pricing model. If traders are willing to pay more for options, the IV that explains that price is higher.

IV is quoted as an annual percentage. An IV of 14% means the market is pricing in price swings of roughly 14% over a year, in either direction. It says nothing about which way the price will move, only how much.

Implied volatility vs historical volatility

When IV is well above historical volatility, options are pricing in bigger swings than the underlying has recently delivered. That often happens before events, or when traders are rushing to buy protection.

Turning IV into an expected move

You can use IV to estimate the price range the market is pricing in:

Expected move ≈ price × IV × √(days to expiry ÷ 365)

Say an index is at 20,000 and its IV is 14% (hypothetical numbers):

This is a one standard deviation range. Under the model’s assumptions, the market is pricing roughly a two-in-three chance that the price stays inside it. Real markets have more large moves than the model assumes, so treat it as a guide, not a promise.

How IV affects option premiums

Higher IV makes both calls and puts more expensive, because bigger expected swings give the option a better chance of finishing in the money. How much the premium changes for each 1-point change in IV is measured by vega.

Say an at-the-money option costs ₹150 and has a vega of 12 (hypothetical numbers):

• IV rises 2 points: the premium rises by about 2 × 12 = ₹24, to ₹174.
• IV falls 4 points: the premium falls by about 4 × 12 = ₹48, to ₹102.

Both happen with no change in the underlying’s price. IV changes only the time value part of the premium, so at-the-money options with more time to expiry are the most sensitive to it.

IV crush: when you’re right and still lose

IV usually climbs before a known event, such as company results, the Union Budget or an RBI policy decision, because nobody knows the outcome. Once the event is over, the uncertainty disappears and IV drops sharply. That drop is called volatility crush.

Say you buy a stock option for ₹200 before results, at an IV of 30% and a vega of 12 (hypothetical numbers). The results come out and the stock moves your way, adding about ₹60 to the premium. But IV falls to 20%, taking away about 10 × 12 = ₹120.

• Premium after results: 200 + 60 – 120 = ₹140
• Result: a loss of ₹60 per unit, even though you called the direction correctly.

This is why buying options just before a big event is risky, and why many traders sell options before events and buy them after.

IV across strikes and expiries

IV isn’t the same for every option on the same underlying.

Across strikes (volatility skew). In index options, out-of-the-money puts usually trade at a higher IV than at-the-money options or out-of-the-money calls, because traders pay extra for protection against a fall. A typical shape looks like this (hypothetical numbers, index at 20,000):

Across expiries. The IV of near-term options jumps ahead of events that fall before their expiry, while longer-dated options react less. Comparing the two shows how much of the expected move is tied to one event.

Is IV high or low? IV rank and India VIX

An IV of 20% can be high for one underlying and low for another, so traders compare IV with its own past range. One common measure is IV rank:

IV rank = (current IV – lowest IV in the past year) ÷ (highest IV – lowest IV) × 100

If an underlying’s IV has ranged between 10% and 30% over the past year (hypothetical numbers):

• At an IV of 15%, IV rank = (15 – 10) ÷ (30 – 10) × 100 = 25, at the low end of its range.
• At an IV of 27%, IV rank = (27 – 10) ÷ (30 – 10) × 100 = 85, near the top of its range.

For the market as a whole, India VIX does a similar job. It’s calculated from Nifty option prices and shows the volatility the market expects over the next 30 days.

How traders use implied volatility

• Buying when IV is low. Option buyers prefer low IV, because the options are cheaper and a later rise in IV adds to the premium.
• Selling when IV is high. Option sellers prefer high IV, because they collect a bigger premium and a later fall in IV works in their favour. Strategies such as short straddles, strangles and iron condors are bets that IV and actual moves will stay lower than expected.
• Sizing positions. The expected move from IV helps set realistic targets and stop-losses.
• Planning around events. Checking how much IV has risen before an event shows how big a move the market is already pricing in.

Common mistakes with IV

• Treating high IV as a direction signal. High IV means bigger expected swings, not that the price will rise or fall.
• Ignoring IV crush. Buying options right before an event often means overpaying for volatility that disappears once it’s over.
• Comparing IV across different underlyings. A volatile stock will always have higher IV than an index. Compare an underlying’s IV with its own history.
• Trusting IV on illiquid strikes. Wide bid-ask spreads on thinly traded options can make their IV readings unreliable.

To see IV and the option Greeks for every strike in real time, use Stolo’s Option Greeks tool, or compare IV across strikes and expiries with Stolo’s option chain analysis.