Quick definition Implied volatility is the volatility level that makes an option's theoretical price equal to its market price. It represents the market's expectation of future price swings. What it is Option prices depend on volatility. Black-Scholes and similar models take volatility as an input and produce a theoretical option price. Implied volatility works backwards: given an option's market price, what volatility level would produce that price? The answer is implied volatility. If implied volatility is 20 percent, the market expects annualised price moves of 20 percent. If implied volatility is 80 percent, the market expects much larger moves. Why it matters IV is the primary driver of option prices, often more important than small moves in the underlying stock. A stock can move 1 percent while IV rises 10 percent (investors becoming more uncertain), causing calls and puts to surge in price. Traders profit from changes in IV without predicting price direction. If you expect IV to rise, you buy straddles (long call + long put). If you expect IV to fall, you sell straddles. IV versus Realized Volatility IV is the market's forecast. Realized volatility is what actually happens. Professional traders compare the two: if you expect realised volatility to be 30 percent but the market is pricing IV at 20 percent, buy volatility (buy options). Term Structure of IV Different expirations have different IVs. Near-term options often have higher IV than distant-term options (or vice versa, depending on market conditions). The curve of IV across expirations is the term structure. Practical example A stock trades at 100 dollars with a 1-month call at 100-dollar strike priced at 2 dollars. IV is 20 percent (annualised). Two weeks later, the stock still trades at 100 dollars, but uncertainty has risen. The same call is now priced at 3 dollars. IV has risen to 35 percent. You didn't move the stock, but options prices rose dramatically due to IV expansion. Traders who bought calls profited; those who sold calls lost. Volatility Smile IV is not constant across strikes. Low-strike puts often have higher IV than at-the-money options. This creates the "volatility smile" shape. This reflects market fears of crashes (puts get expensive because everyone wants protection). See also - Options - Realized Volatility - Vega - Volatility Smile
