Since 1973, when listed call option trading began, investors have been intrigued by the idea of a continuously updated index of the average level of option premiums. Such an index could demonstrate the relative importance of the various factors affecting their value and permit ready comparison of the level of current option premiums with historical levels. The index should measure, not the absolute price of option contracts, but the relative magnitude of the premium over the option’s intrinsic value. And it should relate conveniently to changes in the variables affecting option values—time, interest rates, relationship between striking price of an option and the market price of the underlying stock, dividends, and stock price volatility.
One index with these properties is based on the option market’s implied volatility for the underlying stock. Ordinarily, an investor will enter an estimate of the stock’s future volatility, along with values for the first four of these variables, into an option valuation model, which he then solves for the fair value of the option. If, instead of solving for fair value, he uses the actual price of the option in the equation, he can solve for the implied volatility—the value for the stock price volatility variable implicit in the consensus of buyers and sellers determining the market price of the option on the trading floor of the Exchange.