Implied volatility is a measure of the market's expectation
of how much a particular financial asset, such as a stock or index, will
fluctuate in price over a certain period of time. It is an estimate of the
level of volatility implied by the current market prices of options on that
asset.
In options trading, implied volatility is a key parameter
used to price options contracts. It is an important factor because the price of
an option is directly related to its implied volatility. In other words, the
higher the implied volatility, the higher the price of the option. Implied
volatility is also used to calculate the probability of a stock reaching a
certain price by a certain date.
Some common uses of implied volatility in option trading
include:
Pricing options: Implied volatility is used to calculate the
fair price of options, which helps traders determine whether an option is
overpriced or underpriced.
Identifying mispricings: By comparing the implied volatility
of an option with the actual historical volatility of the underlying asset,
traders can identify potential mispricings and profit from them.
Hedging risk: Traders can use implied volatility to hedge
the risk of their option positions. By buying or selling options with different
implied volatilities, traders can offset their risk exposure.
Forecasting future price movements: Implied volatility can be used to predict future price movements of an underlying asset. High implied volatility suggests that the market expects a lot of price movement in the future, while low implied volatility suggests that the market expects the price to remain relatively stable.
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