Understanding Implied Volatility
In this book, we will discuss the ins and outs of a popular market indicator, or index, that is based on implied volatility. The indicator is the CBOE Volatility Index®, widely known by its ticker symbol, VIX. It should come as no surprise that a solid understanding of the index must begin with a solid understanding of what implied volatility is and how it works.
Implied volatility is ultimately determined by the price of option contracts. Since option prices are the result of market forces, or increased levels of buying or selling, implied volatility is determined by the market. An index based on implied volatility of option prices is displaying the market's estimation of volatility of the underlying security in the future.
More advanced option traders who feel they have a solid understanding of implied volatility may consider moving to Chapter 2. That chapter introduces the actual method for determining the VIX. However, as implied volatility is one of the more advanced option pricing concepts, a quick review before diving into the VIX and volatility-related trading vehicles would be worthwhile for most traders.
HISTORICAL VERSUS FORWARD-LOOKING VOLATILITY
There are two main types of volatility discussed relative to securities prices. The first is historical volatility, which may be calculated using recent trading activity for a stock or other security. The historical volatility of a stock is factual and known. Also, the historical ...