Chapter 36: The Basics of Volatility Trading 733 
At any one point in time, a trader knows for certain the following items that 
affect an option's price: stock price, strike price, time to expiration, interest rate, and 
dividends. The only remaining factor is volatility - in fact, implied volatility. It is the 
big "fudge factor" in option trading. If implied volatility is too high, options will be 
overpriced. That is, they will be relatively expensive. On the other hand, if implied 
volatility is too low, options will be cheap or underpriced. The terms "overpriced" and 
"underpriced" are not really used by theoretical option traders much anymore, 
because their usage implies that one knows what the option should be worth. In the 
modem vernacular, one would say that the options are trading with a "high implied 
volatility" or a "low implied volatility," meaning that one has some sense of where 
implied volatility has been in the past, and the current measure is thus high or low in 
comparison. 
Essentially, implied volatility is the option market's guess at the forthcoming sta­
tistical volatility of the underlying over the life of the option in question. If traders 
believe that the underlying will be volatile over the life of the option, then they will 
bid up the option, making it more highly priced. Conversely, if traders envision a non­
volatile period for the stock, they will not pay up for the option, preferring to bid 
lower; hence the option will be relatively low-priced. The important thing to note is 
that traders normally do not know the future. They have no way of knowing, for sure, 
how volatile the underlying is going to be during the life of the option. 
Having said that, it would be unrealistic to assume that inside information does 
not leak into the marketplace. That is, if certain people possess nonpublic knowledge 
about a company's earnings, new product announcement, takeover bid, and so on, 
they will aggressively buy or bid for the options and that will increase implied volatil­
ity. So, in certain cases, when one sees that implied volatility has shot up quickly, it is 
perhaps a signal that some traders do indeed know the future - at least with respect 
to a specific corporate announcement that is about to be made. 
However, most of the time there is not anyone trading with inside information. 
Yet, every option trader - market-maker and public alike - is forced to make a 
"guess" about volatility when he buys or sells an option. That is true because the price 
he pays is heavily influenced by his volatility estimate ( whether or not he realizes that 
he is, in fact, making such a volatility estimate). As you might imagine, most traders 
have no idea what volatility is going to be during the life of the option. They just pay 
prices that seem to make sense, perhaps based on historic volatility. Consequently, 
today's implied volatility may bear no resemblance to the actual statistical volatility 
that later unfolds during the life of the option. 
For those who desire a more mathematical definition of implied volatility, con­
sider this.