What is Implied volatility in an option contract?

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What is Implied volatility in an option contract?
Option derivatives that have been fast gaining momentum on account of the benefits they offer over other financial instruments derive their price from implied volatility among other factors. Implied volatility is hence an important ingredient that charts the option premium price.

Implied volatility is indicative of the markets sentiments of the underlying option asset i.e. its likely price in the near future. The indicator factors in both the expected future price as well as liquidity of the option contract.

Implied Volatility and Buy-Sell of Option Contracts

When the overall outlook is negative, the volatility across the markets increases. Implied volatility sharing a direct relationship with the option premium price increases the price of the option contract in case of high implied volatility and decrease it in the other scenario. Consequently, high implied volatility suggest sell-off of the underlying option contract and vice-versa.

Historical data is referred to while determining whether the implied volatility of a particular stock or index is high or low. And no two stocks can be compared for concluding implied volatility value as each of the stock has its own range of implied volatility.

In general, implied volatility for option contracts is low in a bullish market outlook when the prices are seen heading northwards and viceversa. This happens as investors associate risk with the falling prices scenario.

Other facts about Implied Volatility

1. Implied volatility shows cyclical movements i.e. on reaching a peak or a bottom level, the indicator heads on to the other direction.

2. The value of the implied volatility for the same stock or index shall vary depending on the expiry date and strike price, which is the fixed price at which the owner of the option contract buys in case of call or sell in case of put position.

3. Effects of corporate action generally pushes implied volatility higher regardless of the fact whether the action will cast a positive or negative impact on the stock or the index.

Thus, implied volatility can be used by investor to determine the purchase or sell price of an option contract.


Story first published: Monday, September 23, 2013, 15:35 [IST]
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