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When first introduced to options it can be easy to brush over the subject of pricing or volatility without realising it’s importance, after all with futures once your position is open all you really need to worry about is whether the price moves in your favour or not. So with this article I hope to plant the seed in the minds of anyone new to options that it’s an extremely important variable to be aware of.

The mathematics behind option price modeling is quite a long and complex subject so we’ll save the intricate details for another time, and today we will simply introduce the idea of implied volatility, explain how it relates to options prices and why they are both important when planning which option strategies to use.

What is Implied Volatility?
Implied volatility is a forward looking figure that tells you what the current price of an option implies about the expected size of future price movements of the underlying asset.

If the market has a view that the future price movements of the asset will be small, then option prices and therefore the corresponding implied volatility figure (IV) will be lower. If the market has a view that the future price movements of the asset will be large, then option prices and therefore implied volatility will be higher.

It is important not to confuse implied volatility with historical volatility (aka realised volatility) which is a measure of how much the asset has actually moved in the past. Whereas implied volatility is the market’s current estimate of future moves (based on the options pricing). It can however be useful to compare these two.

If you only ever looked at the numerical cost of an option it would be quite difficult to tell if it was relatively cheap or expensive as there are several other variables that affect an option’s price other than just the current price of the underlying asset.

With so many different strike prices and expiry dates on offer how can you possibly compare different option prices to one another? The answer is with the corresponding implied volatility figure, and because it is an annualised figure it also allows comparison between options with different expiry dates.

The Effect of Supply And Demand
When market participants are expecting a big move in price, buyers of options will be willing to pay a higher price as they expect the larger move to make up for the larger initial cost. Sellers will also want to charge a higher premium for the options they are selling to account for the (perceived) increased chance of a big move. This will push up option prices which leads to a higher implied volatility figure.

Similarly when future moves in price are expected to be smaller there will be less demand to buy and more participants willing to sell and collect premium, driving down option prices and therefore implied volatility.

Where IV Is Displayed On Deribit
Below we have an example of the current prices of Bitcoin options expiring on 29th March 2019 (in ~19 days at time of screenshot).

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