Implied volatility explained: why options prices rise and fall

Implied volatility represents the market's expectation of how much an underlying security could move over a future period, expressed as an annualized percentage.

Implied volatility explained

For investors who want to know, “What is implied volatility?”, it may be helpful to think of it as the market's estimate of future price movement rather than a prediction of price direction.

Implied volatility reflects the level of movement currently being priced into option contracts. It is commonly expressed as an annualized percentage. For example, an implied volatility reading of 30% suggests the options market is pricing in the possibility of approximately 30% movement over one year, based on the assumptions used in options pricing models.

Unlike measurements based on previous market activity, implied volatility looks forward by reflecting current market expectations. This distinction often comes up in discussions of historical vs implied volatility: historical volatility measures past price fluctuations, while implied volatility reflects expectations embedded in current option prices.

The term "implied" comes from the way the value is calculated. Rather than being directly observed, to calculate implied volatility one must look to existing option prices using options pricing models. After accounting for variables such as the underlying share price, strike price, time until expiration, and interest rates, the remaining variable can be expressed as implied volatility.

Because option prices change throughout the trading day, implied volatility can also change as market expectations evolve.

How IV affects option prices

One of the most important relationships in options trading involves options pricing and implied volatility. As implied volatility changes, option premiums may change as well. 

In general:

• Rising implied volatility may increase the value of both call and put options.

• Falling implied volatility may reduce the value of both call and put options.

This relationship is independent of market direction. A higher implied volatility reading does not necessarily indicate that a stock could move higher. Instead, it reflects expectations for larger price movements in either direction.

For example, before a major company announcement, investors may anticipate greater uncertainty. Increased demand for options during this period can contribute to higher implied volatility, which may also increase option premiums.

Likewise, when uncertainty declines, implied volatility may fall, reducing option premiums even if the underlying stock price has changed very little.

Understanding the connection between option premiums and implied volatility may help explain why two otherwise similar option contracts can trade at different prices under different market conditions.

Understanding IV crush

Among investors who trade options, IV crush is one of the most widely discussed concepts because it illustrates how changes in implied volatility may affect option prices independently of stock price movement.

Scheduled events such as earnings announcements often create uncertainty before the results become public. During this period, market participants may expect the underlying stock to experience a larger-than-normal price move. That expectation can contribute to high implied volatility, increasing option premiums leading up to the announcement.

Once earnings are released, much of that uncertainty may be resolved. Even if the company's results differ from market expectations, the specific event that contributed to elevated implied volatility has passed.

As a result, implied volatility may decline rapidly. This phenomenon is commonly known as IV crush after earnings or implied volatility crush after earnings.

Illustrative example

Suppose a stock is trading at $100 before an earnings announcement.

An investor purchases a call option with a $105 strike price for a premium of $3.00 while implied volatility is elevated.

After earnings are released:

• The stock rises to $104.

• Implied volatility declines significantly.

• The option premium falls to $1.80 because the reduction in implied volatility outweighs the gain from the stock's price movement.

In this simplified example, the stock moved in the anticipated direction, but the option's value still declined because much of the premium reflected elevated implied volatility before the announcement.

This example illustrates why changes in implied volatility can influence option values independently of whether the underlying security rises or falls.

IV rank and IV percentile: putting current IV into context

Looking at implied volatility alone may not provide enough information because different securities can naturally trade with different volatility levels.

For example, one company may commonly trade with implied volatility around 25%, while another may frequently trade above 60%. Comparing these values directly may provide limited context.

This is where IV rank and IV percentile can become useful.

IV rank

IV rank compares the current implied volatility with the highest and lowest implied volatility levels observed over approximately the previous 52 weeks.

The result is expressed on a scale from 0 to 100.

For example:

• An IV Rank of 20 indicates current implied volatility is closer to the lower end of its annual range.

• An IV Rank of 70 indicates implied volatility is closer to the upper end of its annual range.

Rather than comparing different companies, IV Rank helps place each stock's current implied volatility within its own recent range.

IV percentile

IV percentile measures how frequently implied volatility has been lower than its current level during approximately the previous year.

For example:

• An IV Percentile of 70 indicates implied volatility was lower than its current reading on roughly 70% of trading days during the measurement period.

Although both measurements evaluate relative implied volatility, they answer slightly different questions.

IV Rank compares today's implied volatility with the highest and lowest values in the range. IV Percentile compares today's implied volatility with how often lower readings occurred during the measurement period.

Because implied volatility varies widely between securities, both metrics may provide additional context when interpreting whether current implied volatility appears relatively elevated or relatively subdued for a particular stock.

Understanding implied volatility often involves looking beyond the headline percentage and considering where current implied volatility sits within the broader range for that individual security.

The VIX: implied volatility for the entire market

While implied volatility is commonly discussed for individual stocks and exchange-traded funds (ETFs), the VIX provides a broader view of expected market volatility.

The VIX, also known as the CBOE Volatility Index, measures the implied volatility of S&P 500 Index options over approximately the next 30 days. Rather than reflecting expected market direction, it reflects the level of uncertainty currently being priced into those options.

Because it is based on a broad market index, the VIX is often referred to as a measure of overall market sentiment. During periods of heightened uncertainty, option demand may increase, contributing to higher implied volatility and a higher VIX reading. During periods of relatively stable market conditions, the VIX may move lower as expectations for future price swings become more subdued.

Although there is no fixed interpretation for specific values, market participants often group VIX readings into broad ranges:

• Below 15 may reflect relatively calm market conditions.

• Between 15 and 20 may reflect a moderate or transitional level of uncertainty. 

• Between 20 and 30 may reflect elevated uncertainty.

• Above 30 may correspond with periods of increased market volatility.

Because the VIX measures implied volatility for index options rather than individual stocks, movements in the index do not necessarily match the implied volatility of every security. 

Individual companies may experience significantly higher or lower implied volatility depending on company-specific events.

Practical implications of implied volatility

Understanding how implied volatility works can help explain why option premiums vary over time, even when the underlying asset experiences relatively small price movements.

One of the primary drivers of an option's premium is the amount of uncertainty currently reflected in the market. As implied volatility changes, option premiums may also change, regardless of whether the option is a call or a put.

When high implied volatility is present, option premiums generally become more expensive because the market is pricing in the possibility of larger future price movements.

When low implied volatility is present, option premiums generally become less expensive because expectations for future price swings are lower.

Because of this relationship, market participants may evaluate implied volatility alongside other characteristics of an option contract, including:

• Time remaining until expiration

• Strike price

• Underlying stock price

• Interest rates

• Dividend expectations, when applicable

Many brokerage platforms also display IV rank or IV percentile, allowing investors to compare current implied volatility with previous levels for the same security rather than relying solely on the current percentage.

Some investors also monitor scheduled events such as earnings announcements because implied volatility may change before and after these events. As discussed earlier, IV crush after earnings may reduce option premiums even if the underlying asset moves in the anticipated direction.

Understanding these relationships may provide additional context when evaluating options trading decisions. However, implied volatility is only one of several factors that influence option pricing.

Common IV mistakes

Because implied volatility can affect option prices independently of stock price movement, several common misunderstandings may occur when evaluating option contracts.

Buying options before earnings without considering IV crush

One of the most frequently discussed examples involves purchasing options immediately before an earnings announcement without recognizing the potential impact of IV crush. Even when the stock moves in the anticipated direction, declining implied volatility may reduce the option's premium.

Assuming high IV indicates a stock will rise

A common misconception is that high implied volatility suggests a stock could move upward. In practice, implied volatility reflects expectations for the size of future price movement rather than its direction. Large moves may occur upward, downward, or in both directions over time.

Interpreting the VIX as a directional indicator

The VIX measures expected market volatility rather than expected market performance. A rising VIX may coincide with periods of market uncertainty, but it does not indicate whether markets will move higher or lower.

Applying the same IV levels across different stocks

Different companies can naturally trade with different volatility profiles. An implied volatility level that appears elevated for one company may be relatively typical for another. Reviewing IV rank or IV percentile can provide additional context when comparing securities.

Focusing only on stock direction

Options pricing reflects multiple factors, including implied volatility, time remaining until expiration, interest rates, and the underlying asset share price. Considering only the expected direction of a stock may provide an incomplete picture of how an option's premium could change.

Bottom line on implied volatility

Understanding implied volatility involves recognizing that option prices reflect more than expectations about whether a stock may rise or fall. Implied volatility represents the level of future price movement currently being priced into the options market, and changes in that expectation can influence option premiums independently of changes in the underlying stock price.

Concepts such as IV crush, IV rank, IV percentile, and the VIX can provide additional context when interpreting option prices and changing market conditions. Looking at implied volatility alongside other pricing factors may contribute to a more complete understanding of how options are valued.