Implied volatility (IV) is the market’s forecast of how much an asset’s price will fluctuate over the life of an option. It is extracted from the option’s current market price – given all the other known inputs (spot price, strike price, time to expiry, risk-free rate), IV is the volatility value that makes the theoretical price match the observed price.

Higher IV means options are more expensive because the market expects larger price swings. Lower IV means options are cheaper.

IV vs. historical volatility#

Volatility can be measured in two fundamentally different ways:

When IV is significantly higher than recent historical volatility, options are considered expensive – the market is pricing in more movement than has actually occurred. When IV is below historical vol, options are relatively cheap.

How IV is calculated#

IV cannot be observed directly. It is the “plug” variable in an options pricing model. The most common model is Black-Scholes, where IV is the value of σ that satisfies:

C = S₀·Φ(d₁) - K·e^(-rT)·Φ(d₂)

Since there is no closed-form solution for σ, it is found numerically – typically via Newton’s method or bisection. In practice, traders rarely compute IV by hand; pricing engines and protocols handle it automatically.

What drives IV#

• Market sentiment – fear and uncertainty push traders to buy options for protection, driving IV up. Calm markets let IV drift down.
• Events – protocol upgrades, token unlocks, regulatory announcements, and macro events all create expected price movement that inflates IV before the event and deflates it after (volatility crush).
• Supply and demand for options – heavy buying of options increases their price, which mechanically raises IV. Heavy selling compresses it.
• Time to expiry – longer-dated options tend to carry higher IV because more can happen over a longer horizon.

Volatility surface#

IV is not a single number – it varies by strike price and expiration. Plotting IV across strikes and expiries produces the volatility surface.

Two commonly observed patterns:

• Volatility skew – OTM puts tend to have higher IV than ATM options, reflecting demand for downside protection. In crypto markets this skew can be pronounced during drawdowns.
• Volatility smile – both deep OTM puts and deep OTM calls have higher IV than ATM options, forming a U-shape. This is common in crypto where large moves in either direction are expected.

IV and the option greeks#

IV interacts directly with the option greeks:

• Vega measures how much an option’s price changes for a 1-percentage-point change in IV. ATM options have the highest vega.
• Theta (time decay) is connected to IV because higher IV increases the option’s time value, which then decays faster as expiry approaches.

IV in DeFi#

On-chain options protocols must price options without a traditional order book, so they compute IV differently:

• Lyra uses a Black-Scholes-based AMM that adjusts IV dynamically based on the protocol’s net exposure. When the pool is net short options, IV rises; when net long, IV falls.
• Hegic historically used fixed IV inputs set by governance, though later versions moved toward market-driven pricing.
• Opyn (Squeeth) sidesteps per-strike IV entirely by offering a perpetual squared-exposure instrument whose funding rate implicitly reflects volatility.

Because crypto markets are highly volatile relative to traditional assets, IV on tokens like ETH routinely sits at 60–100%+ annualised – far above typical equity IV levels of 15–30%.

Practical relevance#

• Buying options when IV is high is expensive. If IV subsequently contracts (and the underlying doesn’t move enough), the position loses money even if direction is correct.
• Selling options when IV is high can be profitable if realised volatility ends up lower than what was priced in.
• Volatility crush after anticipated events (merges, halvings, FOMC meetings) is a well-known pattern. Traders who buy options before the event and hold through it often lose to the post-event IV collapse.