How to Use Implied Volatility to Forecast Stock Price

Volatility is a measurement of how much a company's stock price rises and falls over time. Stocks with high volatility see relatively large spikes and dips in their prices, and low-volatility stocks show more consistent gains and losses. Implied volatility can be used to project future changes in the price, and it's most often used by investors to evaluate prices on stock options.

It is calculated through a formula using several variables in market and stock price. Knowing a stock's implied volatility and other data, an investor can calculate the degree to which the price might change. But that doesn't forecast which direction the price will move.

Implied Volatility Caveat

Implied volatility is used as a tool to evaluate options, not stocks. Options are vehicles for buying or selling stock or other assets at a specific price at a specific date. Implied volatility helps investors discover a fair price for an option, which can be profitable even when the stock price declines.

Implied Volatility Annual Percentage Forecast

Determine the future date for which you want to use implied volatility to judge a stock's price. Implied volatility is measured as a percentage and is forecast annually. It gives the statistical probability of what a stock's price might be in the future, as measured over a normal distribution graph or bell graph.

Using this graph, the implied volatility shows how far the stock price could change over one "standard deviation," which usually equals 68 percent. For example, a $10 stock with a 20 percent implied volatility has a 68 percent chance to be priced between $8 and $12 one year from now.

Other Factors Influencing Implied Volatility

Find the stock's implied volatility percentage using a financial news website or your online brokerage. Also locate other important information about the stock, some of which could be listed under the stock's "option chain." Investors also need to know the stock's current price and the number of days until the forecast price date. When calculating for options trading, investors need the number of days until the option expires.

Calculating Stock Price's Standard Deviation

First, divide the number of days until the stock price forecast by 365, and then find the square root of that number. Then, multiply the square root with the implied volatility percentage and the current stock price. The result is the change in price.

For example, a $10 stock with a 20 percent implied volatility that expires in six months (183 days) would have a 68 percent chance of rising or falling by approximately $1.41.

Historical Vs. Implied Volatility

Once volatility is no longer "implied" -- it becomes "realized" -- an investor can look at historical volatility. Over a given period, a security's movement regarding its price offers a comparison from its historical volatility to its implied volatility. This comparison may help investors make investing decisions.

Limitations of Implied Volatility

Investors can use implied volatility to help judge market sentiment of a company stock, but it doesn't always take into account certain market factors. Because implied volatility considers historical data and certain market conditions, it doesn't forecast larger market swings based on investor emotions. Investors should consider multiple indicators and data to evaluate stock purchases and investment decisions.