Market participants frequently encounter the concepts of implied and realized volatility but often don't appreciate the difference between the two. Understanding what each describes is critical to fully appreciating a strategy that relies on their comparison. Implied volatility is a number derived from the Black-Scholes options pricing model. Here's how it works. The model assumes that a number of factors play a role in determining an option's price. These include inputs such as the risk-free interest rate, time until expiration, the strike price, the price of the underlying, etc. One of the inputs is volatility. To generate an implied volatility number, we simply solve for volatility instead of the option price, using the current market price of the option as a model input.
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