Implied vs. Realized Volatility: Understanding Market Expectations vs. Reality

Options traders need to distinguish between implied volatility (IV) and realized volatility (RV). IV is based on market expectations, while RV measures actual price movement. The difference between the two creates potential opportunities for options buyers.

What Is Implied Volatility?

Implied volatility represents how much the market expects an asset’s price to fluctuate in the future. It’s derived from option prices, meaning it reflects sentiment rather than actual price action. When IV is high, options become more expensive; when IV is low, they become cheaper.

What Is Realized Volatility?

Realized volatility measures actual price swings over a given period. It’s calculated using historical price data and shows how volatile an asset has actually been, rather than what traders expected.

IV vs. RV: Why the Difference Matters

The gap between IV and RV can highlight mispriced options:

• If IV is much higher than RV, the market may be overestimating future volatility, leading to overpriced options.
• If IV is lower than RV, the market is underestimating volatility, creating opportunities to buy underpriced options.

Using IV and RV to Your Advantage

Buyers can use IV-RV spreads to find favorable trades:

• Buy when IV is low compared to historical and realized volatility, as options are relatively cheap.
• Be cautious when IV is inflated—overpriced options may not provide enough movement to be profitable.
• Monitor how RV evolves post-purchase to ensure the position moves as expected.

Conclusion

Understanding implied vs. realized volatility helps buyers identify mispriced options and improve trade timing. By focusing on these volatility relationships, traders can enhance their ability to find opportunities while avoiding overpriced contracts.