Implied Volatility

This literature review summarizes the academic research on option-implied volatility. It describes algorithms for calculating implied volatility and various weighting schemes used to derive a single volatility estimate from the prices of multiple options, summarizes evidence in the debate on whether to use historical data or implied volatility in forecasting, and reviews several other papers on the various uses of implied volatility, including market efficiency studies and event studies. This review also suggests that implied volatility is being widely misused in practice, describes the schizophrenic notion of the volatility smile, and reviews various methods for calculating a risk-neutral density function consistent with option prices and the new generation of option pricing models (such as Rubenstein's implied binomial tree method) based on these implied volatilities.