Implied volatility is the estimated volatility of a security's price. In general, implied volatility increases when the market is bearish, when investors believe that the asset's price will decline over time, and decreases when the market is bullish, when investors believe that the price will rise over time. This is due to the common belief that bearish markets are riskier than bullish markets. Implied volatility is a way of estimating the future fluctuations of a security's worth based on certain predictive factors.
Implied volatility is one of the deciding factors in the pricing of options. Options, which give the buyer the opportunity to buy or sell an asset at a specific price during a pre-determined period of time, have higher premiums with high levels of implied volatility, and vice versa. Implied volatility approximates the future value of an option, and the option's current value takes this into consideration. Implied volatility is an important thing for investors to pay attention to; if the price of the option rises, but the buyer owns a call price on the original, lower price, or strike price, that means he or she can pay the lower price and immediately turn the asset around and sell it at the higher price.
It is important to remember that implied volatility is all probability. It is only an estimate of future prices, rather than an indication of them. Even though investors take implied volatility into account when making investment decisions, and this dependence inevitably has some impact on the prices themselves, there is no guarantee that an option's price will follow the predicted pattern. However, when considering an investment, it does help to consider the actions other investors are taking in relation to the option, and implied volatility is directly correlated with market opinion, which does in turn affect option pricing.
Another important thing to note is that implied volatility does not predict the direction in which the price change will go. For example, high volatility means a large price swing, but the price could swing very high or very low or both. Low volatility means that the price likely won't make broad, unpredictable changes.
Implied volatility is the opposite of historical volatility, also known as realized volatility or statistical volatility, which measures past market changes and their actual results. It is also helpful to consider historical volatility when dealing with an option, as this can sometimes be a predictive factor in the option's future price changes.
Implied volatility also affects pricing of non-option financial instruments, such as an interest rate cap, which limits the amount by which an interest rate can be raised.