•Implied volatility is a measure of market sentiment as it is a measure of instability of future returns, and is sometimes referred to as the “fear gauge”.
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Properties of Implied Volatility •As this “expected volatility” is defined by market participants’ expectation of how the asset will behave in the future, it is based on existing imperfect knowledge and assumptions about future growth. •As a consequence, it can be very sensitive to news and information flows which may affect the future returns in a market. For example: •An earnings report which is worse than expected is likely to have a negative effect on the value of the equity markets. However, the news may also increase uncertainty in respect of potential future earnings. This uncertainty often translates into an increase in implied volatility. •An earnings report in line with or better than expectation is likely to have a positive and stabilising effect on the value of equity markets. This stability may translate into a decrease in implied volatility.
Properties of Implied Volatility •Furthermore, implied volatility tends to change more sharply than the underlying equity markets. •In particular, during periods when equity markets fall significantly, implied volatility tends to increase sharply, often by much more than the percentage fall in the equity market. •These properties mean than implied volatility can have a strong negative correlation with equity markets, particularly during periods of negative returns,