Using Implied and Historical Volatility

04/18/2011 11:31 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Analyzing implied and historical volatility can help option traders gain a critical edge, while skipping this step can often make for losing trades right from the get-go.

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 a stock with 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 now is 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.

3 Steps for Analyzing Volatility

Implied 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 and historical volatility, but often, volatility charts are 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 was typical 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 and historical volatility on volatility charts is both an art and a science. The basics are shown here, but there are lots of ways implied and historical volatility can interact.

Each volatility scenario is unique. Understanding both implied and historical volatility coupled with a little experience helps traders use volatility to their advantage and gain an edge on each trade.

By Dan Passarelli, author, Trading Option Greeks; founder, Market Taker Mentoring

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