Why Options Are Quoted by Implied Volatility

Summary

The document explains why option traders commonly discuss prices in volatility terms. In a pricing model, inputs such as spot price, strike, time to expiry, and interest rates are treated as observable or specified. Volatility is the uncertain input, so a quoted volatility can be inserted into the model to obtain an option price. This convention lets traders communicate a comparable valuation even as the underlying spot price moves.

The answer also connects the convention to vega, the sensitivity of an option's value to volatility. It gives only a brief account of risk management: traders adjust exposure by buying and selling options. There is no discussion of volatility surfaces, model choice, hedging frequency, or other risk factors that affect option values. The explanation is therefore an introductory intuition, not a full account of how a desk quotes or manages an options book.

Key ideas

• Option pricing models use volatility alongside spot, strike, maturity, and interest rates.
• Volatility is commonly quoted because it is the uncertain model input that determines the option value once other inputs are set.
• A volatility quote allows an option to be repriced as the underlying spot price changes.
• Traders can manage vega exposure by buying or selling options.
• The explanation omits volatility-surface dynamics and operational details of hedging.

Tags

# Why do traders think about options in terms of volatility?


# Why do traders think about options in terms of volatility?












I hear that in practice, traders quote options prices in terms of volatility.

What is this convention, and what is the motivation? How do they think about and manage vega risk?

## Answer by AlRacoon (score 5)

https://quant.stackexchange.com/a/37959

Volatility is in effect what you are trading in options and the one unknown quantity in options valuation.

The other inputs in option valuation: (1) Spot Price: observed in the markets, (2) Strike: defined by contract terms, (3) time: defined by maturity of contract, and (4) interest rates: also observed in the markets.

So in effect volatility is therefore the price of the option, when put into the option pricing model where all the other inputs are known.

Since the Spot Price is constantly moving and therefore the value of the option. When both parties can agree on the volatility, they can then re-price the option at the prevailing Spot Price at the time of the trade.

With respect to managing vega risk, they will both buy and sell options to manage the vega exposure.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.