There are two ways we measure volatility:, which is per strike, and the Vol Index, the VIX-style overall volatility. Both are derived from current option prices. They tell us what the market expects for the underlying. Is one better than the other?
The Vol Index is a weighted average of out-of-the-money (OTM) option prices. Implied Volatility is a Newton-Raphson iterative calculation based on the current option price, its Vega, and an option pricing model (we use Black Scholes). What that means is that to find IV we perform a repeating series of calculations to find IV. It usually takes at most five iterations to find a theoretical value for IV that produces a price close enough to the market. TP explained that it was only with increased power and speed from computers that such calculations were possible. Speeds are advanced enough now that it can be done from a central server and the quotes distributed in real time. TP went through the calculations.
As a benchmark, we often sell options that have an 84% probability of expiring worthless. When volatility is lower the 84% OTM strike (aka the 16strike) is closer to at-the-money (ATM). Higher volatility means the strike is further from ATM. Each method, IV or Vol index, will produce a different number. The difference is because of which makes the OTM Put higher and the OTM Call lower than the Vol. The greater the discrepancy between IV and Vol Index, the greater difference in the 84% strikes. It results in a 2% difference with the Puts being further OTM and the Calls being less OTM. The practical results, based upon 5 years of data, is that the 84% OTM Put using IV expired OTM 96% of the time but 92% of the time for Vol Index while the corresponding Call expired OTM 87% and 90% of the time respectively.
We use IV to calculate the greeks and probabilities for each strike, and for primary trade selection. Vol Index is useful for research and portfolio analysis.
Watch this segment of Skinny on Options Modeling with Tom Preston(aka TP),and for the important takeaways and a better understanding of and when to use IV or Vol Index.