Implied vs. Realised Volatility
Forecast IV versus the market’s actual volatility
What Is Implied Volatility?
Implied volatility (IV) is what the market is saying it expects future volatility to be, based on current option prices. It is obtained by inverting an options pricing model, normally Black-Scholes. That is: given an option’s price, what future volatility would have to occur for that price to be correct? If an option trades expensively, the IV solved for is high. If it trades cheaply, IV is low. IV is expressed as an annualised percentage, typically between 10% (very low and calm) and 100%+ (very high and volatile). IV changes constantly as market perceptions of future volatility change. IV is an expectation, not a fact. It is widely used as a measure of market "sentiment" — high IV suggests fear or uncertainty, low IV suggests complacency.
What Is Realised Volatility?
Realised volatility, also called historical volatility, is the volatility that actually occurred. It is calculated by taking historical price changes and measuring how far they deviated from the average. A stock that moved between 99 and 101 has low realised volatility. A stock that moved between 80 and 120 has high realised volatility. Realised volatility is a historical number — it measures what has already happened. Common periods for calculating it are 20 days (a month), 60 days (a quarter), or 252 days (a year). Realised volatility always looks backwards: it cannot be calculated for the future, only observed once it has happened. Traders constantly compare IV (what the market expects) against realised volatility (what actually happened) to identify discrepancies and opportunities.
When Implied and Realised Diverge
IV and realised volatility are rarely identical. They often diverge significantly, creating trading opportunities. If IV is very high (the market expects large volatility) but realised volatility is low (the stock barely moves), that is a divergence. Option sellers benefit when IV is high but realised turns out low. If IV is very low (the market expects little movement) but realised volatility is high (the stock moves a lot), option buyers benefit. IV typically peaks around anticipated high-impact events, such as earnings, elections or central-bank statements. If the event passes without surprises, IV collapses (IV crush). If the event is surprising, realised volatility can stay elevated even after IV falls. Sophisticated traders build strategies around these expected divergences.
Measures of IV: VIX and Other Indicators
The VIX index is the most popular gauge of implied volatility in the US market. It is calculated from the prices of S&P 500 options and is often called the "fear index". A VIX of 10 suggests very calm markets. A VIX of 30+ suggests significant uncertainty. The VIX is useful as a general market barometer, but it is specific to the S&P 500. Other volatility indices exist for other markets: the VXN for the Nasdaq, the RVX for the Russell 2000, and so on. For individual stocks there is no widely accepted "single-stock VIX", but you can calculate an average IV across strikes to estimate a stock’s IV. Some brokers offer historical IV charts, letting you see whether IV is above or below its historical average. Knowing where IV sits relatively is useful: a very high IV is usually a good moment to sell options, and a very low IV to buy them.
Strategies Based on the Divergence Between Implied and Realised
Traders who specialise in volatility constantly look for disconnects between IV and realised volatility. If IV is in the 90th percentile (very high) but realised is in the 10th (very low), selling options can be a good idea. Conversely, if IV is in the 10th percentile but realised is high, buying options may make sense. The standard method is to calculate the stock’s IV Rank, which places today’s IV within its range over the past year. An IV Rank of 80 means IV sits in the upper part of that range: expensive against its own history. A strategy called "volatility mean reversion" rests on the idea that excessive IV tends to revert to the mean. Volatility traders also use calendars, which exploit the difference in implied volatility between expirations. Under normal conditions the term structure is in contango — distant expirations trade at higher IV than near ones — and the calendar is opened expecting that relationship to hold or steepen. When the structure inverts into backwardation, which is what happens in episodes of immediate panic, the calendar is precisely the structure that suffers.