Implied vs. realized
Market participants frequently encounter the concepts of implied and realized volatility but often don’t appreciate the difference between the two. Understanding what each describes is critical to fully appreciating a strategy that relies on their comparison.
Implied volatility is a number derived from the Black-Scholes options pricing model. Here’s how it works. The model assumes that a number of factors play a role in determining an option’s price. These include inputs such as the risk-free interest rate, time until expiration, the strike price, the price of the underlying, etc. One of the inputs is volatility. To generate an implied volatility number, we simply solve for volatility instead of the option price, using the current market price of the option as a model input.
Realized volatility, on the other hand, is a measure of volatility actually observed in the marketplace. Realized volatility most often is represented by the standard deviation of price changes over a set period of time. It is a direct statistical calculation using recent changes in the price of a stock index.
Although these two measures of volatility are quite related, they do diverge and their relative value to each other is not constant. These deviations often signal trading or investing opportunities in the underlying market.
Marco Erling works as portfolio manager and quantitative analyst for structured products with HSBC Global Asset Management. He studied mathematics at the University of Dortmund in Germany and earned an MBA from ESADE Business School in Barcelona. He is a CFA Charter holder and a Certified FRM holder. Email him at firstname.lastname@example.org.