Related Articles
Start Backtesting

5 Best Implied Volatility Indicators

February 6, 2022
Albert Huang
Tradewell logo

Implied volatility is a key input in the pricing of options and is used by traders to gauge the expected movement of a security's price.

While there are many implied volatility indicators, not all are created equal. In this article, we will explore five of the most important implied volatility indicators. These indicators can be helpful for both experienced and novice traders alike in gauging the market's volatility expectations and responding with appropriate trading strategies.

Key Takeaways
  • Volatility measures the tendency of the price of a security to fluctuate.
  • There are many ways to calculate volatility.
  • Implied volatility differs from traditional measures of volatility because the former is forward-looking, while the latter is backward-looking.
  • Implied volatility is a key factor in the pricing of options. 
  • Because implied volatility is a measure of expected price changes, it is more difficult to quantify with precision than measures of pure volatility.

What is Implied Volatility?

Implied volatility is a measure that seeks to quantify the expected movement of a security's price. It differs materially from historical volatility, which is calculated from the known past returns of a security. Implied volatility is a forward-looking measure of future volatility as opposed to a backward-looking measure of realized volatility.

Before digging deeper into the concept implied volatility, it’s helpful to establish a basic understanding of the more basic concept of standard volatility.

Volatility measures price movements — through returns — of a security over time. Simply put, it is the rate at which a stock's price rises and falls over time. Higher stock volatility typically signals higher risk and a greater likelihood of future price fluctuations. Because volatility is calculated through returns that have been realized in the past, it is considered a backward-looking measure.

Implied volatility measures the expected future realized volatility of a security. If a security exhibits higher implied volatility, it means that investors expect it to experience greater price swings in the future.

Because implied volatility is a key input in the market price of options, higher implied volatility increases the value of option premia, otherwise known as the price a trader pays for an option. In that respect, another way to interpret implied volatility is simply to view it as the price of an option. Implied volatility is in fact less useful at predicting future prices of the underlying than it is at simply communicating the value of the option.

Academic research points to implied volatility as a better predictor of future realized volatility than historical volatility. It also has shown that the predictive quality of implied volatility tends to vary with the volume of options. Therefore unlike measures of standard volatility, implied volatility appears to exhibit significant informational content. Changes implied volatility are generally considered accurate signals of changes in the market’s perception of changes in future return volatility.

How is Stock Volatility Measured?

Volatility is traditionally calculated by using the standard deviation of the logarithmic returns of a security over time. In statistics, standard deviation measures the amount of variation or dispersion of a set of values. The purpose of the volatility measure is to express the degree to which the returns of a stock tends to vary from its mean return. As such, standard deviation is a fitting input to include in a standard calculation of volatility.

There are in fact a wide range of different methods that financial professionals use to measure a stock’s volatility. While the formulas used to calculate volatility may differ, they share a common thread in that they all aim to capture the tendency of a given security to fluctuate over time. 

The volatility measure known as beta is one that is commonly used by portfolio managers. As a measure of relative volatility, beta seeks to communicate how an individual asset moves in relation to the overall market. A US stock whose beta value exceeds 1 can be considered likely to rise when the S&P 500 rises, but to a greater degree than the index itself. Likewise when the index falls, high beta stocks are expected to decline more than the benchmark.

Because implied volatility measures expected returns that have yet to occur, building models to approximate its value is more challenging than building models to calculate standard volatility. Nevertheless, Implied volatility is commonly calculated by inputing the market price of an option​ into the​ Black-Scholes formula and then back-solving for the value of volatility. It’s important to note that when traders apply different models applied to the same market option prices, they will produce different implied volatilities.

As a rule of thumb, implied volatility usually increases during bear markets and decreases during bull markets. This is becasase

There is ongoing debate over whether implied volatilities have predictive value when it comes to forecasting the future price movements of securities.

5 Recommended Implied Volatility Indicators

We’ve assembled a list of what we consider five of the best implied volatility indicators for traders of US equities. Each measurement has its own strengths and weaknesses, so it's important to understand how they work before you start using them in your trading. With a little practice, though, you'll be able to use these indicators to gauge market sentiment and make more informed trading decisions.

1. CBOE Volatility Index (VIX)

The world's premier barometer of equity market volatility, the VIX Index details the expected change in the value of the S&P 500 over the next 30 days. The value of the index is derived from S&P 500 Index options for the 30 days following its measurement date. Critics of the VIX cite that it functions primarily as an indicator of variance, rather than volatility.

2. CBOE 3-Month Volatility Index (VIX3M)

Like the VIX itself, the VIX3M is a constant measure of implied volatility for the S&P 500. However, because it measures volatility over a three-month timeframe, the index tends to be less volatile than the VIX, which measures one-month volatility.  The 3-Month Volatility Index is also normally higher than VIX, a condition called contango.

3. VIX/VIX3M Ratio

You can identify periods of time when the market is bearish and bullish by comparing the value of different indexes. By comparing the value of the VIX to the value of the VIX3M, you can identify periods when trader sentiment has turned extremely bearish.  Such a condition might be highlighted by that ratio trading over 1, which happens when the VIX futures contracts enter a period of backwardation.

4. CBOE 9-Day Volatility Index (VIX9D)

This shorter-time frame indicator estimates the expected volatility of the next nine days. There are two additional forms of VIX9D, VSTN and VSTF, that estimate the expected volatility in stock returns by incorporating the near term and far term S&P 500 Index option series, respectively, into their calculations.

5. CBOE 6-Month Volatility Index (VIX6M)

This index estimates the expected volatility of the stock market over a span of six months. It is calculated by analyzing S&P 500 Index options with a time frame of 6-to-9 months.

How Does Tradewell Track Implied Volatility?

The backtesting and data visualization web app Tradewell tracks thousands of indicators, including many measures of implied volatility. Not only does the platform allow traders to monitor all of the five broad-market implied volatility metrics mentioned in this article, but it also tracks a large number of the single-stock and ETF-based volatility indices originating from the CBOE volatility index family.

For traders who prefer to track the implied volatility of individual equities, Tradewell also offers its premium members tools to monitor hundreds of fixed maturity and fixed strike implied volatilities for individual stocks.

And for traders hungry for even more implied volatility indicators, Tradewell offers a wide range of proprietary volatility spreads such as VIX-MAD, an indicator which measures the spread in value between the VIX Index and the Mean Average Deviation for the S&P 500. Experienced traders will recognize that this indicator is used to measure the "volatility risk premium or discount", or, said another way, the cost of options in implied volatility compared to the Mean Average Deviation (MAD) of the underlying asset.

A full list of all implied volatility indicators can be found within the documentation pages for the Tradewell platform. And because the Tradewell is both a backtesting and analytics web app, traders can not only monitor these indicators, but also measure and analyze how changes in their values have historically impacted the future price of specific securities.

Final Thoughts

Implied volatility indicators can be a great tool for traders, providing information that can help them make more informed decisions, especially as relates to risk. However, it's important to understand that not all implied volatility indicators are the same.

It is imperative therefore that traders become familiar with a variety of implied volatility indicators so that they can apply the one that best fits the scenario they are trading.

In addition, traders should be aware of the limitations of these indicators and use them in conjunction with other tools in order to increase their chances of success. 

Read This Next
Albert Huang
Deep Out of the Money Options Strategy Explained‍
A deep out of the money option contract is a financial instrument traders use to wager that the price of a security will be far different from the current price at some point in the future.
Read Article
Humza Sarwar
VWMA vs VWAP: Calculation, Trading, and Settings
Understanding how VWAP and VWMA are calculated, how to interpret their output, and when to use them can potentially help traders become better at their craft. 
Read Article
Albert Huang
Extrinsic vs Intrinsic Value Options: 3 Key Differences
Anyone who trades options seriously should be able to answer one of the most fundamental options questions: from where do options get their value?
Read Article
Albert Huang
5 Predictive Stock Market Indicators
The indicators that traders use to determine the future prospects of individual securities and of the market at large are wide ranging. However, not all indicators are created equal.
Read Article
Humza Sarwar
3 Effective Options Strategies For a Sideways Market
Traders often find it difficult to profit from stock in “sideways markets” as the stock trades within a narrow range of support and resistance.
Read Article
Humza Sarwar
Is Averaging Down a Good Idea?
Averaging down is a simple strategy investors use for this purpose. When investors average down, they add shares of an existing position at a lower cost basis.
Read Article
Humza Sarwar
What is an h-pattern in trading and how to trade it?
An h-pattern is a chart pattern that emerges when a security that has fallen precipitously later retests the low point of its recent decline, making fresh lows.
Read Article
Albert Huang
What is the Break-Even Price of an Option? 
In options trading, the term “break-even price” describes the price that the underlying shares of an options contract must reach by the option’s expiration in order for the owner of the option to avoid losing money on its purchase.
Read Article
Albert Huang
How to Find a Trading Edge
In this article, we'll discuss the concept of edge and teach you how to use the Tradewell platform to identify whether or not your trading strategy provides one.
Read Article
Albert Huang
5 Best Implied Volatility Indicators
While there are many implied volatility indicators, not all are created equal. In this article, we will explore five of the most important implied volatility indicators.
Read Article
Humza Sarwar
Put vs Short: Know the Difference
Although buying put options and short selling may seem similar, there are key differences when it comes to their suitability for different trading strategies, and their risk and return profiles.
Read Article
Get started with Tradewell for free

Start with the free version and upgrade when you need a larger metric library and longer lookback periods.

TradeBlock logo
FRED logo
CBOE logo
IEX logo
EIA logo
CME Group logo
Tradewell logo
© 2021 Tradewell, Inc. All rights reserved.
Start Backtesting