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Definition of 'Implied Volatility'


Definition: In the world of option trading, implied volatility signals the expected gyrations in an options contract over its lifetime. Investors and traders use it to determine option pricing. Many experts in derivatives trading look at this indicator as a more important tool than time value of an option for pricing a contract.

Implied volatility alerts an investor of the possibility of uneven changes in the price of the underlying security, as it is dependent on demand and supply of a particular option contract as well as expectation of the direction of share price.

Description: Implied volatility helps investors gauge future market volatility. It has a positive correlation with the expectation of stock price and is one of the six parameters used to determine the price of an option. If investors believe the price of a stock will rise in the future, then implied volatility will rise, whereas if they expect the price to fall, then implied volatility will decline.

How does implied volatility affect the price of an option? Lower implied volatility means the price of an option will fall. The time value of an option, talked about earlier, hence becomes cheaper or expensive depending on the fall or rise in implied volatility.

The formula for the calculation of Implied Volatility is as follow:

s˜2pT---v.C/S

wherein,
s= Implied volatility
T= Duration of the option contract
C= Call price of the option contract
S= Strike price of the contract

The term is of great importance to traders and investors, as the success of their trade can be greatly increased depending on whether they are on the right side of the volatility. Short-dated options have lower sensitivity to implied volatility whereas long-dated options have higher sensitivity to it as the time value is priced into such option in a higher quantity.
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