Implied Volatility is a key concept when it comes to options trading. The Black-Scholes option pricing model requires several inputs, most of which are readily observable in the market. One variable in the formula that cannot be directly observed is the volatility of the underlying stock’s price. Thus investors must make do with implied volatility, which can be found by using the Black-Scholes formula and working backwards from the option price. While this may not give us the “true” volatility, it will tell us what the market, via the options price, believs the volatility is.

Q. Many arbitrage strategies involve using options, and this term is a key element of those strategies. What is it, exactly?

A. Well, any option price has a few components. The most important is the price of the security you’re getting the right to buy or sell. Then, there’s the time value of money that you’re paying. But that leaves the most interesting piece, the price that people are paying for the volatility of the option, which is implied by deducting the other, known, pricing elements from the exiting market price.

Q. Now, how does that relate to Black Shoales, which you did on another buzzword segment?

A. That’s the classic formula that solved the ancient puzzle about how to price options: the key insight was how to price the historic volatility of the underlying security: the more volatile the performance has been, the more valuable an option to buy or sell it is.

Q. So, Black-Shoales essentially tells us what an option “should” be priced at, at least from an academic point of view. But I guess the market doesn’t always agree.

A. Right. And thereby hangs a tale, because lots of traders do think options frequently get mispriced in the real world. If he sees an implied volatility that is “out of line” with Black-Shoales (or whatever similar theory a trader believes in… often, of course, they have their own, especially as you move across different asset categories: bonds, commodities, etc. ), then might be an opportunity for volatility arbitrage.

Q. And how does that work?

The trader is pretty sure that he’s looking at an anomaly in the pricing of the option, and he can create an arbitrage by, for example, buying the option and selling the underlying security. Then, if the option pricing comes back to where it “should” be, the trader makes a profit.

Q. Great. But what about individual investors? Is implied volatility important for them?

A. Yes. Lots of folks like to play an expected move in a stock by buying options on it, because of the leverage you get. But they can be disappointed, because the stock might move as expected, but the option price doesn’t. That happens when the move is already “priced in” to the option, which you can often see by comparing the implied volatility of the option to the Black-Shoales price.