Implied Volatility Ratio

The implied volatility ratio is a tool to help investors evaluate the fair price of an option.

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Volatility measures the range of change in a stock's price over a given period, and implied volatility is used by investors to forecast the future performance of a stock. Companies with high volatility see greater swings in their stock prices, compared with low-volatility companies that are generally more stable. Implied volatility is a vital concept for investors who trade in stock options, as they use it to judge if an option is fairly priced. An implied volatility ratio is one of several ways to evaluate option prices. Both financial news websites and online investment brokerages provide implied volatility data on stocks with options.

Implied Volatility in Stock Options

Options are contract-like investments in which owners of a company stock agree to sell a lot of shares at a specified strike price on a certain expiration date in the future. These contracts are traded between investors for an ask price based on strike price and expiration. A option is valuable if the company's strike price is projected to be less than market price on the expiration date -- a circumstance called "in the money" -- and sellers can charge higher ask prices for in-the-money options. Investors use implied volatility to help determine if the ask price for an option is fair.

Finding the Implied Volatility Ratio

Implied volatility is a measurement of how much the market believes a stock's price will fluctuate in the future. It is expressed as a percentage and provided by option brokerages and some financial news websites. The implied volatility ratio is derived by dividing an option's implied volatility with its historical volatility, with a ratio of 1.0 being a fair price. An option with a ratio of 1.2 is overpriced and selling at 20 percent more than its value, while an option with a 0.7 ratio is 30 percent undervalued and a bargain for an option buyer. .

Using Implied Volatility Data

Evaluating a fair ask price of an option using implied volatility can be done in several ways, with the Black-Scholes model being the most widely used. Online brokerages will provide a variety of data based on the Black-Scholes price, which is calculated with data such as expiration date, price, interest rates and past volatility measurements. Investors can evaluate the Black-Scholes price by dividing it with the current ask price of an option. As with the implied volatility ratio, any option with a value of greater than 1.0 is overpriced.

Measuring Over Time

Black-Scholes prices can be calculated to reflect a range of time periods to better match an option's details. For example, an option that expires in 45 days would be better evaluated using a 50-day price, as compared to those measured over 100 or 200 days. Implied volatility data are meant as indicators and don't factor in all market forces, such as price movements fueled by investor emotion or business developments such as mergers.