Useful Tools to Calculate an Option's Implied Volatility

If you are trading stocks or options, it will be useful for you to calculate implied volatility. Volatility is the term used to denote the stability of a given stock’s price, in relation to other stocks in the same industry.  If it is very reactive in comparison, it is considered highly volatile.

Implied volatility attempts to predict how volatile the stock will be in the future based on the market’s view on the matter. This is in contrast to the term historical volatility, which denotes how volatile the stock has been in the past.

Volatility is especially important because the more volatile a stock is, the more expensive it is. You can even think of implied volatility as a price and not how it will move in the future. This measure can be used to manage risk and to trigger trades. You can even trade options on the market's own volatility level if you are so inclined. Implied volatility tends to increase with the market is bearish and decrease when it is bullish because bearish markets are considered riskier than bullish ones.

Find Stock Information

The information you will need to calculate the implied volatility of the stock are:

  • stock price
  • risk-free rate
  • time expiration (this is also called the theta of the stock)
  • volatility (denoted by vol)
  • stock’s dividend yield

Calculating the Implied Volatility with the Black-Scholes Pricing Model

We will be using the  Black-Scholes pricing model to calculate implied volatility. This model is used to find the “theoretical fair value” of the option. If the market price is higher than the theoretical fair value, it is considered overvalued. If the market price is lower than the theoretical fair value, it is considered underpriced and therefore considered “cheap”.

There are Excel spreadsheets available on the internet. You can go to “Tools”, then “Macros”, then “Visual Basic Editor”. Then choose “View” and then “Project Explorer”. Click on “Procedures”, in the Modules section.  Drag and drop this item into your project folder.

Then, choose whether your option is a call or a put from the pull down menu. Put this information into the functional areas. Maximum error should not exceed one percent.  Now you can check for the accuracy of the figured you arrived at by comparing the Black-Scholes model price at this volatility, and the Market Price.

Alternately, you can forgo Excel and use implied volatility calculators found on the  internet.

Approximating Implied Volatility

Implied volatility can also be quickly estimated, using the following equation:

  • Implied Vol = P / (0.4 F Square root (T) )
  • P is the price of the option
  • F is the forward price
  • T is time to expiration (years)

If the option has a short date, you can use the spot price.