Implied volatility

What implied volatility actually measures

Black-Scholes takes five inputs to price an option: spot, strike, time to expiry, the risk-free rate, and volatility. Four of those are observable. Volatility is not — it's a forecast of how much the underlying will move over the option's life. Implied volatility inverts the problem: instead of feeding in a vol to get a price, you take the option's traded price and solve for the vol that reproduces it. So IV is not a property of the stock; it's a property of the option's price. When traders say 'NVDA IV is 55', they mean the option market is pricing roughly 55% annualised standard deviation of returns until expiry. Divide by 16 (the square root of 252 trading days) to get the daily expected move: 55/16 ≈ 3.4% per session.

IV vs realized volatility — the core edge

Realized (historical) volatility is what the stock actually did; implied volatility is what the option market expects it to do. The persistent gap between them is the variance risk premium: on average IV trades above subsequent realized vol because option buyers pay up for insurance and sellers demand compensation for tail risk. That premium is why systematic option-selling strategies have positive expectancy in calm regimes — and why they detonate when realized vol finally exceeds the implied vol that was sold. The trade is never 'IV is high so sell'; it's 'IV is high relative to what realized vol is likely to be'.

IV rank and IV percentile

Absolute IV is meaningless without context — 30% IV is high for KO and low for a biotech into an FDA decision. Two normalisations fix this. IV rank places current IV between its 52-week high and low: rank = (IV − IV_low) / (IV_high − IV_low). IV percentile is stricter — the fraction of days in the past year that IV closed below today's level. A name at 30% IV with an IV percentile of 85 is expensive for itself; the same 30% at percentile 12 is cheap. Premium sellers want high IV rank/percentile; long-gamma and long-vega buyers want low.

• IV rank > 50 → options richer than their yearly midpoint
• IV percentile > 80 → at the top of the yearly distribution, mean-reversion favoured for sellers
• IV percentile < 20 + known catalyst → asymmetric setup for buyers
• Always pair the read with realized vol — high IV is justified if the stock is actually moving

The volatility surface: skew and term structure

A single IV number hides two dimensions. Across strikes, equity options show skew: out-of-the-money puts trade at higher IV than equidistant calls, because crashes are faster than melt-ups and put demand for hedging is structural. Across expiries, the term structure is normally upward-sloping (contango) in calm markets and inverts (backwardation) under stress, when near-dated IV spikes above longer-dated. Reading both keeps you from being blindsided: a flat-to-inverted term structure into an event tells you the market is pricing the catalyst into the front month, and a steep put skew tells you downside protection is already crowded and expensive.

IV crush around earnings

Before a binary event — earnings, an FDA ruling, an FOMC decision — IV in the expiry that captures the event inflates to price the expected jump. The moment the news prints and uncertainty resolves, that event premium evaporates, often 30-50% of the IV gone by the next open regardless of direction. This is IV crush, and it's why buying a straddle the day before earnings so often loses even when the stock moves: you paid for an expected move the option already had baked in. The disciplined plays are either selling the inflated premium (defined-risk, because the tail can still gap through your strikes) or structuring calendars that are long the cheap back month and short the rich front month.

How desks actually trade IV

Vol is traded as its own asset. Relative-value desks compare a name's IV to its sector, to the index, and to its own history, then buy the cheap leg and sell the rich one delta-hedged, isolating the vol view. The VIX itself is just a 30-day constant-maturity IV across the SPX option chain, which is why VIX futures, VIX options, and variance swaps exist — direct instruments to express a view on implied vol without touching a single stock. For a retail trader the practical workflow is narrower but the same logic holds: check IV percentile, compare to realized, look at skew and term structure, and only then decide whether you're a net buyer or seller of volatility.