What it is
Implied volatility is the volatility number that, when put into an option pricing model, reproduces the option's traded price. It is not observed in the market directly; it is extracted from price, and it is best read as the market's collective estimate of how much the underlying will move over the option's life, quoted as an annualised percentage.
How it works
It is found by numerically inverting a model such as Black-Scholes for the volatility input. Because that model assumes a single constant volatility and real markets do not behave that way, implied volatility varies by strike, producing the smile or skew, and by expiry, producing the term structure. Equity index options display a pronounced downside skew, with puts priced at higher implied volatility than calls, which reflects persistent demand for crash protection rather than an error in anyone's arithmetic.
How traders use it
Traders use it comparatively. IV rank and IV percentile place the current level against its own history so that a strategy can lean toward selling premium when volatility is historically expensive and buying it when it is cheap. The gap between implied and subsequently realised volatility is the variance risk premium, and the collapse of implied volatility immediately after a scheduled event such as earnings or a central bank decision is the well-known volatility crush.
Where it breaks down
Implied volatility says nothing about direction, and a high reading is not by itself a reason to sell options. Implied exceeds realised volatility on average precisely because sellers are being paid to absorb tail risk, and the occasional payout of that risk is large enough to erase years of collection. It is also model-dependent, since a different model produces a different implied number from the same price, and percentile comparisons across genuinely different volatility regimes can be badly misleading.
Educational reference. This entry describes how a concept is defined and used. It is not investment advice, not a recommendation, and not a signal. Any rule you build from it should be tested with realistic costs before it is traded, and no historical result guarantees a future one.