Definition
Implied volatility (IV) is the annualized volatility of the underlying asset that, when entered into an option pricing model, reproduces the option's current market price. It reflects how the market is pricing future movement, not a measured past quantity.
How it works
IV is solved backward: the model takes the underlying price, strike, time to expiry, interest rate, dividends and the observed option price, and the unknown volatility is adjusted until the model matches the market. It is quoted as an annualized percentage and usually differs across strikes and expiries.
All else equal, higher IV means higher premiums for both calls and puts. IV often rises when markets fall or before known events such as earnings, then drops once the event passes. It is commonly compared with realized volatility, the actual past movement of the underlying.
Formula / convention
Solve for σ in: Market option price = Model price(S, K, t, r, q, σ); Expected one-standard-deviation move ≈ S × σ × √t (t in years)
Illustrative example
A fictional share priced at HK$100 has an implied volatility of 30% a year. Over one month an approximate one-standard-deviation move is 30% × √(1/12) ≈ 30% × 0.2887 ≈ 8.7%, or about HK$8.7, under the model's assumptions. That describes a typical range, not a limit: larger moves occur regularly.
What to watch for
Implied volatility reflects model-dependent option prices, not the direction of the underlying or a guarantee of future movement size, and different models or inputs can give different IV values.