Historical volatility (HV) is the volatility derived 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 20 historical volatility is less volatile than a stock with a 25 historical volatility. Much of this can usually be seen by the naked eye as well. With this recent turbulent market, many current historical volatility levels are trading above levels from as little as a month ago.

In contrast to historical volatility, which looks at actual stock prices in the past, implied volatility (IV) looks toward the future. 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 10% implied volatility to be less volatile than a stock with a 30% implied volatility. It is like comparing a volatile stock like Tesla Motors (TSLA) to, say, Bank of America (BAC). TSLA is the more volatile stock and the implied volatility of the options proves that. 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, particularly going forward.

To analyze implied volatility and historical volatility, we use a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful guide that makes it easy to compare implied volatility and historical volatility. Many option-friendly brokers use volatility charts, but they are often misinterpreted by new or less experienced option traders.

Option traders need to look at three different criteria when analyzing volatility. First, they need to compare current implied volatility with current historical volatility. This helps traders understand how volatility is being priced into options in comparison with the stock’s volatility. If the two are out-of-whack so to speak, an opportunity might exist to buy or sell volatility (i.e., options) at a “good or inflated” 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 and may be “cheap.”

Second, traders must 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 usual, it may be expensive and possibly a good time to be selling premium. If it is below its normal level, it may be a good time to buy premium because options may be underpriced.

Lastly, traders need to complete their analysis by comparing historical volatility at the moment with what historical volatility was in the recent past. The historical volatility chart can indicate whether current stock volatility is more or less than in the past. If current historical volatility is higher than it was typically 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 discrepancy known as the skew by buying options priced too cheaply.

Flipping things around, if historical volatility has fallen below levels that have been typical in the past, option 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 good opportunity to sell premium.

As I like to say, there are a lot of moving parts when it comes to learning about options. But having a general understanding of volatility cannot be stressed enough. The buy low sell high principle should be remembered when analyzing volatility.

John Kmiecik, Market Taker Mentoring