Volatility is one the key differences between investing in options and investing in stocks. It may be the single most important difference between the two financial vehicles.
As a result, understanding volatility in detail is critical to your long term strategy. For all intents and purposes, you cannot know too much about this esoteric, complicated topic.
In its broadest form, volatility is broken down into two categories: historical and implied. Every premium on an options contract is based on these two calculations. An earlier blog post discussed how options brokers assess implied volatility in every contract they sell.
Here is what you need to know to understand the other side of the equation.
What is historical volatility?
Historical volatility is otherwise known as statistical volatility. It is based on the historic price data for an option’s underlying stock.
This is a measure of how often and by how much a stock’s price has moved in the past. As a result, it is not based on actual value but rather on the value movements. An asset trading steadily at $1 per share for six months and another one trading at $100 per share will have the same volatility of zero, because neither one moved.
For example, take a volatility model for GameCo with a stock price trading at $10 per share on January 1. If, over the course of the year, the stock dips as low as $7 and raises as high as $12 it would be considered highly volatile even if it ends right back where it started.
This, by the way, is why data is critical when it comes to investing. See our trading products to get the data you need to make sound trading choices.
How is it priced?
Through historical volatility, traders are essentially trying to predict how much a stock’s price will change in the future based on how much it has changed in the past.
That means that actual calculations encompass a wide range of factors. Although a typical historical deviation measures stock prices over the course of a year, traders can set whatever parameters they like.
For example a normal deviation measures stock prices over the course of a year, but you can set that as high or low as you want. A 10 day volatility measure is as viable as a 10 year volatility measure. Similarly, you can set the increments over which trades are evaluated. For example, one trader may measure the change in stock prices every 10 days, while another may measure how much the stock changed prices each month.
How should you use it?
With historical volatility, the data matters as much as the final number. Remember that with options trading, you need to predict in which direction the stock will move, by how much, and by when. So it is important to know not just the raw deviation statistic but also information like in which directions the stock swung and if it showed any discernible patterns.
Beyond the raw data, traders use the relationship between historical and implied volatility to determine whether options are selling hot or cold.
When historical volatility dramatically outpaces implied volatility levels, it means that the market expects the stock to be less volatile than history would predict it should be. This means that now may be a time to buy options because they may be underpriced.
By contrast, when historical volatility is much lower than implied volatility, it suggests that the options market expects the stock to move far more than its past trends. Now may be the time to sell options contracts, while they are overpriced relative to what the data would imply.
Of course, that is just one approach. Always remember, if data could always beat the market, Excel would be a lottery ticket.
Even so, trading backed by good data has a better chance of being profitable than trading that is not based on good data. Want to see how better data impacts your trading success? Try Market Timer for one month for an incredibly low introductory rate.