Volatility: The Key to Success in This Market

Not sure if you have noticed, but the market has been pretty volatile. Not only have stocks and ETFs been volatile, implied volatility has spiked for options. But what is implied volatility and how does it compare to historical volatility? Let’s take a quick below.

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. To keep it really simple, HV is the chart. With this recent volatile market, many historical volatility levels came close to or passed record high levels.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. To try to keep it simple again, it is how options are currently priced.

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 such as Tesla (TSLA) to, say, Bank of America (BAC). TSLA is the more volatile stock and the implied volatility of the options prove that. At the time of this writing, the IV for TSLA was 109% and the IV for BAC was 80%. 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.

I like to compare implied volatility to itself. In other words, look at the IV over the course of a year. Is it currently higher now than, say, six months ago? This helps traders understand whether implied volatility is high or low in relative terms. If implied volatility is higher than typical, the options may be expensive and it could be a good time to sell premium. If it is below its normal level, it may be a good time to buy premium because options may be underpriced. Generally, the answer is yes in this current market environment. I can see historical volatility on the chart, but I can compare current option prices to the past.

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

John Kmiecik, Market Taker Mentoring

Trader Education