The proper definition is based on the underlying mathematics:
- Option pricing formulae take five parameters - spot price, time to expiry, strike price, risk free interest rate, and historical volatility - and result in the theoretical or 'fair' value of the option contract. This tells us that the historical volatility would warrant the theoretical price or fair value.
- Real price and fair value are seldom the same. Putting the real price in place of theoretical price and solving the formula for volatility will tell us what market volatility is implied by the real price, i.e. what historical volatility would make the fair value same as the real price.
In an options portfolio each option has its own implied volatility (IV). Plotting the IV for each strike price gives us the volatility "smile" that is sometime not a smile at all. (If deep in the money and far out the money options volatility is lower than that of at the money strike prices, the volatility smile is in fact a frown.)
Volatility smile can change over time, as IV's of different options respond to market conditions differently. A change in volatility smile can have profound effect on a portfolio's risk and outcome.
OptionScape allows individual options' IV to be analyzed separately and together thus caters for changing or propagating constant IV scenarios into the future to expiry of the last position.
To set an IV scenario select the contract whose IV you want to set. The corresponding line will turn dark blue. Place the mouse pointer on the line, hold down the left mouse button and "draw" the scenario with the pointer.
You can repeat the process for each option contract, or you can click on the "Copy" button to copy the scenario over to all the other options in the strategy. When all scenarios are shown as parallel curves the volatility smile is constant throughout the lifetime of the strategy.