What is implied volatility in relation to options pricing?

Implied volatility refers to the market's expectation of the future volatility of the underlying asset's price as reflected in the pricing of options. It serves as a crucial metric in the options pricing model, demonstrating how much the market believes the asset's price will fluctuate over a certain period. When traders and investors engage in options trading, they assess how much they think the price of the underlying asset will move. This forecast is embedded in the pricing of the option itself, leading to higher implied volatility when there is a belief that significant price movements are likely.

In this context, implied volatility acts as a predictor of potential price fluctuations and is vital for understanding market sentiment. Higher implied volatility typically indicates that traders anticipate larger price swings—either up or down—whereas lower implied volatility suggests that price changes might be more modest. Using implied volatility assists traders in making informed decisions about buying or selling options, since it provides insight into how market participants view the potential future activity of the underlying asset.

Other options, such as the actual price fluctuations, past performance data, or fixed rates of return, do not accurately characterize implied volatility, as they either reflect historical data or do not pertain to market expectations of future movements. Implied volatility is purely a forward-looking measure