Failing to analyze components like implied volatility and historical volatility before placing an option trade is a mistake that commonly results in losses that could have been easily avoided.
One of the most important steps in any option trade is to analyze implied volatility and historical volatility. This is the way option traders can gain edge in their trades. But analyzing implied volatility and historical volatility is an often-overlooked step, thus making some trades losers from the start.
Implied Volatility and Historical Volatility
Historical volatility (HV) is the volatility experienced by the underlying stock, stated in terms of annualized standard deviation as a percentage of the stock price. Historical volatility is helpful in comparing the volatility of one stock with that of another stock or to the stock itself over a period of time.
For example, a stock that has a 15 historical volatility is less volatile than a stock with a 25 historical volatility. Additionally, a stock with a historical volatility of 35 is now more volatile than it was when its historical volatility was, say, 20.
In contrast to historical volatility, which looks at actual asset prices in the past, implied volatility (IV) looks ahead.
Implied volatility is often interpreted as the market’s expectation for the future volatility of a stock. Implied volatility can be derived from the price of an option. Specifically, implied volatility is the expected future volatility of the stock that is implied by the price of the stock’s options.
For example, the market (collectively) expects a stock that has a 15 implied volatility to be less volatile than a stock with a 30 implied volatility. The implied volatility of an asset can also be compared with what it was in the past. If a stock has an implied volatility of 40 compared with a 20 implied volatility, say, a month ago, the market now considers the stock to be more volatile.
See related: Using IV to Predict Future Price Action
Implied volatility and historical volatility are studied using a volatility chart. A volatility chart tracks the implied and historical volatility over time in graphical form. It is a helpful visual aid that makes it easy to compare implied volatility and historical volatility. But volatility charts are often misinterpreted by novice traders.
Volatility chart practitioners need to perform three separate analyses. First, they need to compare current implied volatility with current historical volatility. This helps the trader understand how volatility is being priced into options in comparison with the stock’s volatility. If the two are disparate, an opportunity might exist to buy or sell volatility (i.e., options) at a “good” price.
In general, if implied volatility is higher than historical volatility it gives some indication that option prices may be high. If implied volatility is below historical volatility, this may mean option prices are discounted.
But that is not the end of the story. Traders must also compare implied volatility now with implied volatility in the past. This helps traders understand whether implied volatility is high or low in relative terms. If implied volatility is higher than typical, it may be expensive, making it a good a sale; if it is below its normal level, it may be a good buy.
Lastly, traders need to complete their analysis by comparing historical volatility at this time with what historical volatility was in the recent past. The historical volatility chart can indicate whether current stock volatility is more or less than it typically is. If current historical volatility is higher than it was in the past, the stock is now more volatile than normal.
If current implied volatility doesn’t justify the higher-than-normal historical volatility, the trader can capitalize on the disparity by buying options priced too cheaply.
Conversely, if historical volatility has fallen below what has been typical in the past, traders need to look at implied volatility to see if an opportunity to sell exists. If implied volatility is high compared with historical volatility, it could be a sell signal.
The Art and Science of Implied and Historical Volatility
Analyzing implied volatility and historical volatility on volatility charts is both an art and a science. The basics are discussed here, but there are lots of ways implied and historical volatility can interact.
Each volatility scenario is unique. Understanding both implied and historical volatility combined with a little experience helps traders use volatility to their advantage and gain edge on each trade.
By Dan Passarelli of MarketTaker.com