Implied volatility is a measure of the expected future volatility of an underlying asset based on the prices of options on that asset. It is an important concept in options trading because options prices are highly sensitive to changes in implied volatility.
Implied volatility is calculated using an option pricing model, such as the Black-Scholes model, which takes into account the current market price of the option, the strike price, the time to expiration, the risk-free interest rate, and the current price of the underlying asset.
Implied volatility is expressed as a percentage and represents the annualized standard deviation of the underlying asset's price movements over the life of the option contract. It is called "implied" because it is derived from the observed market price of the option and reflects the collective expectations of traders and investors about future price volatility.
In general, when implied volatility is high, option prices are more expensive because there is a greater likelihood of the underlying asset experiencing significant price swings. Conversely, when implied volatility is low, option prices are less expensive because there is less expected price movement in the underlying asset.
Traders can use implied volatility to help determine whether options are overpriced or under-priced relative to historical volatility or the trader's own volatility expectations. For example, if implied volatility is significantly higher than historical volatility, a trader may consider selling options as a strategy to take advantage of the higher premiums. Conversely, if implied volatility is significantly lower than historical volatility, a trader may consider buying options as a strategy to take advantage of potentially undervalued premiums.