PROFESSOR: In the context of the Black-Scholes-Merton model,

implied volatility is defined as the level of the volatility

parameter, sigma, such that given the other formula inputs,
the model price for an option matches its market price.
For example, say we know from the table we looked
at earlier today that the market price of a put option
with a strike price of $1,500 and a time to expiration
of 0.12 is equal to $20.35.
We can find the implied volatility, sigma sub
imp, where "imp" stands for implied,
by using the Black-Scholes-Merton formula
for the price of a put calibrated
with the other inputs we know and solving it
for sigma sub imp that's consistent with that observed
market price of the option.
Clearly this means that every option in the market
can potentially have a different implied volatility.
You may have heard the term volatility
smile or volatility smirk.
Those terms refer to the typical shape of implied volatility
when plotted as a function of the moneyness
of the underlying option, holding
all the parameters other than the strike price fixed.
For example, this figure shows that there is a volatility
smirk implied by the market prices for put options
given in the table we looked at earlier.
Had the implied volatility started
increasing for high levels of moneyness as sometimes happens,
it would have been described as a smile instead of a smirk.
For comparison, the volatility estimate
we saw based on the last three months of data
is also plotted on the graph, as is the volatility estimate that
comes out of just looking at the last month of data.
Under these market conditions, the implied volatilities
were all higher than the last month of historical volatility,
but similar on average to the historical volatility based
on a three month look back.
The relationship between implied volatility
and historical volatility can vary considerably over time.
That's because implied volatility is forward looking
and expectations about the future
can become quite different than what was
experienced in the recent past.
Estimates of implied volatility are
useful for several purposes.
One is simply to get a forward looking read on how
market participants gauge the amount of general market
uncertainty.
Higher uncertainty translates to higher options
prices, which in turn means higher implied volatilities.
Remember that Vega, the effect of volatility
on options prices, is always positive,
both for puts and calls.
The graph here compares implied volatilities,
indicated by the lighter dashed line,
to volatilities estimated using historical data,
the solid line.
The two series tend to track each other over time,
but sometimes there can be significant differences
between them.
A few regularities stand out.
One is that implied volatility tends
to be higher than historical volatility,
and that the difference becomes more pronounced during periods
where volatility is unusually high.
Those differences are consistent with options prices containing
a risk premium that isn't captured
by the Black-Scholes-Merton model.
I thought you might be interested in seeing
some more recent data on implied volatilities.
This graph plots the VIX from 2017 through October of 2021.
The VIX is the most commonly used measure
of implied volatility for the overall stock market
and we'll talk more about it shortly.
The graph shows that the stock market was relatively calm
over the earlier part of this period.
The onset of the COVID-19 panic caused implied volatility
to spike sharply, and then to stay elevated
over pre-pandemic levels.
A very practical use of implied volatility
is to look for profitable trading opportunities
in the options market.
If you look directly at the prices of options
with different maturities and strike prices,
it's impossible to directly evaluate
which are relatively expensive and which are relatively cheap.
With different strike prices, there
are differences in intrinsic value, which
is the difference between the stock price and the strike
price.
Those differences have a significant but variable effect
on the value of an option.
Different maturities are hard to compare
because that entails adjustments for time value and uncertainty.
For example, if you were to directly compare the market
price on May 3, 2007 of two of the put options we looked
at with maturity of 0.12, one with a strike price of $1,500
and another with a strike price of $1,475,
you would find $1.00 difference between them of $7.75.
You wouldn't know how much of a difference
to attribute to the $25 difference in their strike
prices and how much to attribute to something else.
Instead of looking directly at prices
to make value comparisons, you could take the data
and create what's called an implied volatility surface.
An implied volatility surface plots
implied volatility on the vertical z-axis
of a three-dimensional graph with maturity and moneyness
on the x- and y-axis.
This can make it much clearer which options appear cheap
and which appear expensive.
An option with a higher implied volatility compared
to its close neighbors on the volatility surface
are relatively expensive, controlling
for the most important sources of price variation.
Options that are significantly below the surface, that
have a relatively low implied volatility, are cheap.
A trading strategy then is to buy options
that seem significantly underpriced
and to sell options that appear to be significantly overpriced.
Be warned though, if you do this without hedging those trades,
you're very exposed to changes in market conditions
that affect the value of your position.
A more prudent strategy would be to delta or delta gamma
hedge those trades using liquid options
or a replicating portfolio of the underlying stock
or a combination of the two.
By hedging, you're then left with a pure bet
on the price of the overpriced or underpriced option moving
back in line with other options.
The VIX is an index of the S&P 500 implied volatility
based on options traded on the S&P 500
index at the CBOE with expirations
between 23 and 37 days.
Note that the VIX is based on an average across options
with different amounts of moneyness,
and that the individual implied volatilities on the underlying
contracts may differ significantly
from the average that's the VIX.
For that reason, the VIX is useful in trading strategies
based on general trends in stock market volatility.
Both futures and options are traded on the VIX.
And those derivatives can be used to hedge or to speculate.
A long position in volatility means
that you profit if volatility rises and vice
versa for short positions.
An example of using the VIX to hedge
would be for an index fund manager who's
compensated based on how closely his portfolio tracks the S&P
500 index.
Because tracking error tends to rise with volatility,
the manager can hedge his compensation
by buying a contract whose payoff increases
with volatility.
A speculative example is if you want
to make a directional bet on what will happen to market
volatility and you want to avoid a directional bet
on whether the market will rise or fall.
Recall that you can also use options
to bet on volatility using long and short positions
in straddles and strangles.