For over a decade I have been teaching people about options and the VIX. The VIX was always something that intrigued people, but little understood. I always began a discussion of the VIX by asking, “what is the VIX?” Interestingly, the responses were varied and seldom conveyed the understanding of what it is measuring. In this introduction, we’re going to delve into the basics of implied volatility as a foundation for understanding the VIX.

You might be curious about what people’s responses were. Well, typically people would call it a “fear index.” While I understand why they call it that, I was given a similar explanation when I learned about the VIX over 15 years ago, but if that’s as deep as you go you’ll never really grasp how to use it. I feel that the VIX and other volatility indices for the SPX are some of the most significant means of developing a market posture from a forward-looking perspective, so let’s dig deeper!

What is Implied Volatility?

 The answer that I was looking for to my question, “what is the VIX?” was that it was average implied volatility for SPX options. Simple, right? The reason why that doesn’t resonate with people learning how to trade options is that implied volatility is one of the more difficult and esoteric concepts for most students of option trading to learn.

In order to wrap our minds around the implied volatility, let’s start by breaking down the words “implied” and “volatility.”

Implied—According to dictionary.com, the word implied is defined as, “suggested without being directly or explicitly stated.” This definition makes a lot of sense when used in conjunction with volatility. Since future stock prices aren’t known, any expectation of what price will do in the future has to be implied. For options, the implied expected movement of the stock price is derived from the option price.

Volatility—this probably conjures up some bad memories of a statistics class you took in college, but don’t let it scare you off. What you want to remember from statistics class is that volatility measures how prices are dispersed or scattered.

Imagine if you were to plot the daily prices of a stock. What are some of the characteristics of that price plot over time? The first observation should be that there are no negative values for the stock price, and the values are heavily skewed to the right. The first part is pretty easy intuitively since stock prices can’t have a negative value. The other part can be pretty easy to understand if you were to look at long-term charts of many stocks, they tend to go up over time. The reason why this is significant is to understand that stock prices are not normally distributed like a bell curve. In order to do statistical analysis for the dispersion of stock prices we have to first take the natural log of the stock prices. After this is done, you’ll find that the dispersion of price is normally distributed. Thus, stock prices are said to have a log-normal distribution.

Once we understand that stock prices can be normally distributed by taking the log of the price, we can begin to use statistical concepts for measuring volatility and the associated probability. The statistical term for associating dispersion and probability is a term called, standard deviation.

 Definition for option implied volatility:

Implied volatility is the future expected movement of the stock price expressed as a percent. That percentage is one standard deviation of price movement for one-year.

For example, if you observe that the implied volatility for a particular option is 30%, what does that value mean? First, it tells you that the price is expected to move positively or negatively by 30% over the course of the next year. Second, it tells you that the price is expected to stay in that range about 68% of the time.

Simple, right? Well, maybe not at first, but a rudimentary understanding is likely all that is needed to be able to begin using implied volatility in your trading.

How is Implied Volatility Determined?

 The common response to this question is that it is determined by the option maker. However, this isn’t true. The option maker may be adjusting the option price, but it is an attempt to find where the market equilibrium price is at that moment.

For example, if there were a dearth of option sell orders and an overabundance of option buy orders, it might be suggested that the price is too low. If the various inputs that affect option prices like strike price, stock price, interest rates and time haven’t changed significantly; the market derived premium added to the option price is therefore implied volatility. As the option price is adjusted and brought into equilibrium, we now have a price to work out the future expectations “implied” in the option price.

So, the future expected movement of the stock price, or implied volatility, is derived directly from the option price. The part of the premium that can’t be explained by time, strike, stock price and interest rates is the part of the option premium based on the future expected movement or implied volatility.

Analyzing Implied Volatility

 Most platforms allow you to view implied volatility in line with each option strike price. However, each strike price and expiration will have slightly different implied volatilities. There are expected relationships between the implied volatility as the options move into and out-of-the-money. There are also expected relationships of how implied volatility changes over time. The degree that these implied volatilities fall outside of the normal expected structure it is referred to as Skew.

For this initial look at what implied volatility is, I’m not going to get into skewness. Initially what most people analyze is average implied volatility. Since each expiration and strike has slightly different implied volatilities, in order to come up with an average you need to decide what should be included. Typically, out-of-the-money options without a zero bid would be included.

My intent is to not delve into how the average is calculated, but rather that an average can be calculated and used to compare historically or diachronically. By comparing against its own historical values you get a sense of whether average implied volatility (or option prices) is relatively high or low.

 Now that you have a foundation in what implied volatility is, you’re now able to begin to think about the VIX. The VIX itself represents the average implied volatility of S&P 500 Index options set to expire in around 30 days.

Conclusion

 Implied volatility explains the amount of expected movement priced into the option premium, and it is expressed as an annualized standard deviation. Understanding implied volatility allows you to grasp how options are relatively priced, it allows you to understand the degree of expected movement and also the associated probabilities of a price being reached. Understanding implied volatility is critical to your understanding of the VIX and to your option strategy selection.