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In financial mathematics , the implied volatility of an option contract is that value of the volatility of the underlying instrument which, when input in an option pricing model such as Black—Scholes will return a theoretical value equal to the current market price of the option.
A non-option financial instrument that has embedded optionality, such as an interest rate cap , can also have an implied volatility. Implied volatility, a forward-looking and subjective measure, differs from historical volatility because the latter is calculated from known past returns of a security. An option pricing model, such as Black—Scholes , uses a variety of inputs to derive a theoretical value for an option. Inputs to pricing models vary depending on the type of option being priced and the pricing model used.
In general, it is not possible to give a closed form formula for implied volatility in terms of call price. However, in some cases large strike, low strike, short expiry, large expiry it is possible to give an asymptotic expansion of implied volatility in terms of call price. In general, a pricing model function, f , does not have a closed-form solution for its inverse, g.
Instead, a root finding technique is used to solve the equation:. While there are many techniques for finding roots, two of the most commonly used are Newton's method and Brent's method.
Because options prices can move very quickly, it is often important to use the most efficient method when calculating implied volatilities. Newton's method provides rapid convergence; however, it requires the first partial derivative of the option's theoretical value with respect to volatility; i. If the pricing model function yields a closed-form solution for vega , which is the case for Black—Scholes model , then Newton's method can be more efficient.
However, for most practical pricing models, such as a binomial model , this is not the case and vega must be derived numerically. When forced to solve for vega numerically, one can use the Christopher and Salkin method or, for more accurate calculation of out-of-the-money implied volatilities, one can use the Corrado-Miller model. As stated by Brian Byrne, the implied volatility of an option is a more useful measure of the option's relative value than its price.
The reason is that the price of an option depends most directly on the price of its underlying asset. If an option is held as part of a delta neutral portfolio that is, a portfolio that is hedged against small moves in the underlying's price , then the next most important factor in determining the value of the option will be its implied volatility.
Implied volatility is so important that options are often quoted in terms of volatility rather than price, particularly between professional traders. The implied volatility of the option is determined to be Even though the option's price is higher at the second measurement, it is still considered cheaper based on volatility. The reason is that the underlying needed to hedge the call option can be sold for a higher price.
Another way to look at implied volatility is to think of it as a price, not as a measure of future stock moves. In this view it simply is a more convenient way to communicate option prices than currency. Prices are different in nature from statistical quantities: A price requires two counterparties, a buyer and a seller. Prices are determined by supply and demand.
Statistical estimates depend on the time-series and the mathematical structure of the model used. It is a mistake to confuse a price, which implies a transaction, with the result of a statistical estimation, which is merely what comes out of a calculation. Implied volatilities are prices: Seen in this light, it should not be surprising that implied volatilities might not conform to what a particular statistical model would predict.
However, the above view ignores the fact that the values of implied volatilities depend on the model used to calculate them: Thus, if one adopts this view of implied volatility as a price, then one also has to concede that there is no unique implied-volatility-price and that a buyer and a seller in the same transaction might be trading at different "prices".
In general, options based on the same underlying but with different strike values and expiration times will yield different implied volatilities. This is generally viewed as evidence that an underlying's volatility is not constant but instead depends on factors such as the price level of the underlying, the underlying's recent price variance, and the passage of time.
There exist few known parametrisation of the volatility surface Schonbusher, SVI and gSVI as well as their de-arbitraging methodologies. Volatility instruments are financial instruments that track the value of implied volatility of other derivative securities.
There are also other commonly referenced volatility indices such as the VXN index Nasdaq index futures volatility measure , the QQV QQQ volatility measure , IVX - Implied Volatility Index an expected stock volatility over a future period for any of US securities and exchange traded instruments , as well as options and futures derivatives based directly on these volatility indices themselves. From Wikipedia, the free encyclopedia. Retrieved 9 June Application to Skew Risk".