Most traders don’t realize this, but volatility is oftentimes the most important factor to influence an option’s price over time.
At the most fundamental level, volatility means movement of the underlying asset.
But when it comes to options, volatility is a bit more complex than simply measuring the movement of the stock or asset you’re trading.
There are two main types of volatility: historical and implied.
Understanding the difference between historical and implied volatility and the basic principles of each can go a long way to help you become a successful options trader.
Learning the Difference Between Historical and Implied Volatility: Historical
Historical volatility is displayed as a percentage.
It measures how much the asset moved on a daily basis over a specified period of time, and it can always be directly measured.
To give you an example, assume you’re looking at a stock priced at $20 per share that’s had an average daily trading range of $0.50 over the past four months…
This means the volatility over the past 120 days was about 2.5%, which is considered to be fairly low historical volatility.
On the other hand, if its volatility level was 20% or 30% over 120 days, the historical volatility would be high.
When a stock has a higher historical volatility, the price of the option is higher because a stock that moves substantially over time has a higher chance of continued movement… which is what the option buyer wants!
When a stock has low historical volatility, the option would have a lower price because there’s a lower chance the option will move much…
And as a result, the option buyer has less profit potential.
For example, tech stocks such as Apple Inc. (Nasdaq: AAPL) and Amazon.com Inc. (Nasdaq: AMZN) have much higher historical volatility than blue-chip stocks. That’s because tech stocks are naturally more volatile than blue chips and have a higher chance of bigger movement over time.
Traders often buy and sell options based on historical volatility even though they’re making a decision based on what’s already happened.
While the past never repeats itself the same way, it gives a good indication of how the underlying asset may behave in the future.
Learning the Difference Between Historical and Implied Volatility: Implied
Implied volatility is derived directly from the option’s actual market price. It shows what the market “implies” about the underlying asset’s volatility going into the future.
Without making things too complicated, implied volatility is also displayed as a percentage, and is based on what the market believes the option is worth at any given time.
So implied volatility is derived from the options price and based on what the market is willing to pay for the option at that time.
Implied volatility is determined by an options pricing model.
The main difference between historical and implied volatility is that implied can’t be determined by looking at the underlying asset like historical volatility can.
Implied volatility is one of several variables used in an options pricing model, but it’s the only one that’s not directly determined by looking at market price.
Implied volatility can only be determined by knowing all the other variables, and solving it by using a model.
Since the majority of trading volume occurs in at-the-money options, these are the type options generally used to calculate implied volatility.
Once we know the price of at-the-money options, we can use an options pricing model and a math formula to find the implied volatility of that particular option.
Higher implied volatility levels reflect a higher expected fluctuation in the underlying asset. Lower implied volatility levels, however, reflect a lower expected fluctuation.
To determine implied volatility levels on a particular stock, you need to use a pricing model.
The most common one is called the Black-Scholes model.
Fortunately, the majority of options brokerage firms offer clients trading software that provides access to this options model.
To use the model, you have to enter the variables that can be determined. That includes things like the stock price, strike price, interest rate, dividend, expiration date and the actual price of the option.
Most option chains include implied volatility without you having to enter this data manually.
You will often find that options with high implied volatility tend to have wider bid-ask spreads than options with low implied volatility.
This is because high implied volatility levels don’t give us clues as to the future direction of the underlying asset.
It only gives us an indication of the degree of potential movement over time.
This increases speculation in both directions and ultimately widens the spread between the bid and offer.
But the key difference between historical and implied volatility is that implied is forward looking while historical is looks back.
For more information about market volatility, check out these posts: What Is the VIX? Understanding Stock Market Volatility and How to Track Volatility With the VIX.
I hope that helps!
Senior Strategist, WealthPress