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. Take a look at a stock chart to get a feel for historical volatility.

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 (TSLA) to, say, Microsoft (MSFT). TSLA is the more volatile stock and the implied volatility of the options prove 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.

Implied volatility and historical volatility are analyzed using 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 (which are most) will have them. But often volatility charts are misinterpreted by new or less experienced option traders.

An option trader needs to look at three different criteria when analyzing volatility. 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 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.”

However, just because implied volatility is higher or above historical, doesn’t mean you should blindly sell premium and vice-versa. For example, if IV is high and a put spread is sold, does it make a difference that “expensive” premium was sold if the underlying continues to move against the spread?

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, but to me it is just as important to forecast what the underlying will do.

John Kmiecik, Market Taker Mentoring