3.1 Implied and Realized Volatility

💡 In this article, you will learn about:
  • Implied volatility
  • Realized (historical) volatility
  • Implications of volatility in DeFi options

Volatility in DeFi Options

Volatility is a measure of how much and how fast the price of an asset such as ETH can change over a short period of time.

In the DeFi markets, volatility is especially important to understand, as it directly affects the risk and return of different DeFi products such as options and liquidity pools.

There are two ways to measure volatility: implied volatility and realized volatility.

Understanding Implied Volatility

Implied volatility is an estimate of how uncertain and unpredictable the price of an asset will be in the future.

It's like predicting the weather over the next few months. Just like a weather forecast, implied volatility is based on various factors and conditions.

When the forecast indicates high volatility, traders may be more likely to purchase options to profit from potential price swings. Conversely, when the forecast calls for low volatility, traders may be less likely to purchase options, and may use strategies more fit for calmer markets, such as selling options.

If the markets are implying a high level of volatility for an asset like ETH, the price is expected to move a lot in the future.

If the markets are implying a low level of volatility for an asset like ETH, the price is expected to move less.

Realized Volatility: Historical Price Movement

Realized volatility (also called historical volatility) measures the past price movement of an asset over a specified period.

Realized volatility can be used to find correlations and historical patterns, as well as used as an indicator of the actual price risk of an underlying asset.

For example, if implied volatility is higher than realized volatility, it means that the markets expect unusually high volatility in the underlying asset. Among other implications, this means an option might be overpriced on average, signaling traders to sell premiums.

Realized volatility is an indicator of the actual historically recorded price risk of an underlying asset.

Implied volatility is an indicator of the expected future price risk of an underlying asset.

Implications for Traders and Investors in DeFi

Understanding implied volatility is especially important, since it directly affects the pricing of options and the risk-return profile of DeFi options strategies.

Pricing

High implied volatility means that an option is more likely to expire in the money. This means a higher premium since the buyer has a higher chance of profiting, and the seller takes on more risk. As a result, options with low implied volatility generally have a cheaper premium, while high implied volatility results in a more expensive premium.

Implied Volatility in DeFi

DeFi protocols and digital assets operate in a highly dynamic environment, which can lead to rapid changes in market conditions and implied volatility. It is important for traders and investors alike to stay informed about the volatility of the assets they are exposed to, and how it might impact pricing and risk.

In summary, volatility is a crucial concept in the DeFi market, and understanding implied and realized volatility can help traders and investors make more informed decisions.

Test Yourself!

What is the difference between implied and realized volatility?

  • Implied volatility doesn't matter, since it's not based on actual data.

  • Implied volatility is based on what the markets expect, whereas realized volatility is based on historical data.

  • Realized volatility is real, while implied volatility is merely an analyst's prediction.