Mathematical algorithms used for computing the Implied Volatility using the

Market price and the Black-Scholes Model Price

Using the Black Scholes model, obtaining a reliable estimate of the volatility or standard
deviation is challenging. Moreover, the Black-Scholes-Merton model and option prices are
extremely sensitive to Volatility. The two approaches for estimating the volatility using the
Black-Scholes Model are; Historical volatility and Implied volatility, denoted as σ.

It assumes that the option’s market price reflects the underlying’s current volatility. Implied
volatility is the standard deviation that makes the Black-Scholes-Merton option price equal
the option’s current market price. The Black Scholes model is unable to calculate Implied
Volatility because it cannot be arranged to solve the Standard Deviation of the Options. Due
to this ,trial and error method is used to calculate the implied volatility of the options until
the Black Scholes option price is equal to the Market price of the option.

When the implied volatility is graphed against the exercise price, this relationship forms a U-
shaped pattern that is referred to as the “Volatility Smile”. Often, the shape is more skewed,
and the resulting pattern is called the “Volatility Skew”. The volatility smile or skew indicates
that the Black-Scholes-Merton option pricing model is not a perfect to calculate the volatility
through Trial and Error basis.

To overcome the limitations of Estimating Implied volatility from the Black Scholes method,
many researchers and scholars have come up with models used to calculate implied volatility.
In this article we will discuss two of the most important models in the calculating the implied
volatility of the options.
1. Newton Raphson method of calculating the implied volatility by Manaster and Koehler,
1982
2. Corrado-Miller model, extended version of the chance model, 1996

 Manaster and Koehler (1982), using the Newton Raphson Model to calculate implied
volatility
According to the Black and Scholes model, Option price is a function of the “Time to
maturity (T)” of the option, “Exercise price(X)”, “Current price(S)” of the underlying
stock, “Risk-free rate of interest (R)”, and “Implied Volatility” or Variance.
To avoid Trial and Error method, over the years, several authors, rather than
estimating a variance from past data, have attempted to employ the Black-Scholes
option pricing formula to derive "implied variance”. Unfortunately, the implied
variance cannot be calculated easily, and previous researchers have used numerical
methods such as the Newton-Raphson method and its variants. However, for many
options, no values of implied variance could be found to justify the observed option
prices because of many reasons like, Volatility for Out of money or In the money
options was not accurate, Inaccuracy was detected when time to maturity was less
than 3 months etc. To overcome these problems, in 1982, Manaster and Koehler came
up with a derivation of The Newton Raphson method by including non-linear
equations and using guess equations to arrive at Implied volatility.
A common numerical method used for solving nonlinear systems of equations is the
Newton-Raphson method;

where Vn is the nth estimate of v*, and f' is the first derivative of F(v). Since f'(vn) > 0
when t,x, and c > 0, Vn+1 is well defined over (0, ∞).
A well-known result concerning the Newton-Raphson procedure gives that if the
above equation has a solution, there is an open interval of v* such that if Vn >0
When this is the case, convergence is quadratic, through which we arrive at a equation
to get the implied volatility of the Option.

Manaster and Kohler (1982), provided a shortcut that can provide a solution to the
trial and error problem. The formula for implied volatility initial guess according to
Manaster and Kohler is:

X- Spot price
T- Time to Maturity
C- Strike price
R- Risk free rate

The Newton Raphson model is very fast, if the initial guess of the equation taken ins
accurate, this can be done by analysing the historical views on volatility of options.
According to some researchers this method becomes very inaccurate when the strike
of the option is more than 20% Away-From-The-Money. Further, if the Vega has
small error, it leads to large errors while calculating implied volatility.
  In 1996, Corrado and Miller reported an extended model of Chance Model that, unlike
the Chance Model, it estimates implied volatility without requiring option prices
rather than the price of the target options. It was an extension of the Brenner-
Subrahmanyan formula for calculating implied Volatility. The formula reported by
Corrado-Miller was:

C- price
X- Strike
S- Spot
T- Time to maturity
σ- Implied Volatility

One problem with Corrado and Miller’s model is that it includes a square root term
that, in some cases does not have a solution for negative terms. Specifically, for short
term options, that are very considerably out of the money, the formula requires the
square root of a negative value. Due to this the user isn’t sure if the formula will
produce an error, although the problem is unlikely to occur for reasonable
parameters.
Corrado and Miller’s model is highly accurate for options near At-The-Money. but
deteriorates for options far Out of Money or In the money. The model also fails to
produce real solutions like short term options very far from the money. The models
biggest flaw is that the solution comes out to be imaginary in many cases.
Overall, these results suggest that this method yields relatively more accurate results
when only call premiums are used, when compared to put.

Finally, in spite of what the majority of financial managers believe, there are analytical
expressions to calculate the implied volatility from option prices. The problem with these
closed formulas is that sometimes they are too complicated. In fact, each function can even
have more than thirty parameters and each parameter, therefore each parameter has to be
estimated very accurately to get the right results. There is a lot of room for improvement in
this field and perhaps future researches will propose an analytical solution to this problem
that will manage to replace these approaches
References:
 https://medium.com/hypervolatility/extracting-implied-volatility-newton-raphson-
secant-and-bisection-approaches-fae83c779e56
 https://www.diva-portal.org/smash/get/diva2:506716/FULLTEXT01.pdf
 https://www.jstor.org/stable/2327127?seq=2#metadata_info_tab_contents
 http://www.eecs.harvard.edu/~parkes/cs286r/spring08/reading3/chambers.pdf
 https://core.ac.uk/download/pdf/6418428.pdf