Implied Volatility

The application of the Black-Scholes formula as described in the last section is not the modern way in which it is used. As pointed out, the weak link in applying the formula is the choice of the volatility parameter. To circumvent this issue, a different way to apply the formula was devised in which the volatility parameter was given a new interpretation.

Rather than trying to guess what value to use for the volatility parameter, the modern approach is to insert the actual option price from the marketplace into the Black-Scholes formula, and then let the formula tell us what the volatility should be. The value of the volatility parameter determined in this manner is called the implied volatility, or IV for short.

A major drawback ...

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