Implied volatility (IV) is derived mathematically from an option's current market price, using a pricing model (typically Black-Scholes). It represents the market's consensus forecast of how much the underlying asset will move over the option's remaining life — expressed as an annualized standard deviation percentage. If a stock has an IV of 40%, the options market implies a roughly 40% annualized standard deviation in price — or about a 2.3% daily move (40% ÷ √252).
IV vs Historical Volatility
Historical volatility (HV) measures how much the stock actually moved in the past. Implied volatility measures what the market expects it to move in the future. The relationship between IV and HV reveals trading opportunities:
- IV > HV: Options are expensive relative to recent actual volatility. Option sellers (who receive the premium) tend to benefit if IV reverts toward HV.
- IV < HV: Options are cheap. Option buyers may get favorable pricing if actual volatility continues at its recent pace.
IV Crush
IV typically spikes before binary events — earnings, FDA approvals, FOMC decisions — because the potential for large price moves is highest. After the event resolves, IV collapses rapidly even if the stock moves significantly. This is IV crush. Traders who buy options before earnings often lose money even when they correctly call the direction — the IV drop reduces the option's time value faster than the price move increases intrinsic value.
Experienced traders either sell options (to collect elevated IV before events) or buy options well before the event while IV is still moderate — not immediately before when IV is at its peak.
VIX: The Market's IV Gauge
The VIX index measures the implied volatility of S&P 500 options and is often called the "fear gauge." VIX above 20 signals elevated market uncertainty; above 30 signals significant fear. Because IV tends to mean-revert, extended periods of high VIX often precede lower volatility (and vice versa) — though timing the reversion is difficult.