Testimonials

December 15, 2011

Implied Volatility and Historical Volatility

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 10:09 am

One of the most important steps in any option trade is to analyze implied volatility and historical volatility. This is the way option traders can gain edge in their trades. But analyzing implied volatility and historical volatility is often an overlooked step making some trades losers from the get-go.

Implied Volatility and Historical Volatility
Historical volatility (HV) is the volatility experienced 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 15 historical volatility is less volatile than a stock with a 25 historical volatility. Additionally, a stock with a historical volatility of 35 now is more volatile than it was when its historical volatility was, say, 20.

In contrast to historical volatility, which looks at actual asset prices in the past, implied volatility (IV) looks ahead. 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 15 implied volatility to be less volatile than a stock with a 30 implied volatility. 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.

Analyzing Volatility
Implied volatility and historical volatility is studied using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful visual aide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are  misinterpreted by novice traders.

Volatility chart practitioners need to perform three separate analyses. 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 disparate, an opportunity might exist to buy or sell volatility (i.e., options) at a “good” 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.

But that is not the end of the story. Traders must also 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 typical, it may be expensive, making it a good a sale; if it is below its normal level it may be a good buy.

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

Conversely, if historical volatility has fallen below what has been typical in the past, 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 sell signal.

The Art and Science of Implied Volatility and Historical Volatility
Analyzing implied volatility and historical volatility on volatility charts is both an art and a science. The basics are shown here. But there are lots of ways implied volatility and historical volatility can interact. Each volatility scenario is unique. Understanding both implied volatility and historical volatility combined with a little experience helps traders use volatility to their advantage and gain edge on each trade.

Edited by

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 31, 2011

The Two Faces of Volatility

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 2:32 pm

In Roman mythology the god of beginnings and endings, Janus, is typically portrayed having two heads, each facing in opposite directions. His countenances are displayed in this manner so that he can observe the past as well as the future.  The two types of option volatility, historical volatility and implied volatility, also reflect this dual perspective.

Historical volatility, also termed statistical volatility by some writers, is a simple mathematical calculation of the demonstrated volatility over various periods of time, hence the name historical volatility. While the precise method of calculation of historical volatility can be argued endlessly, it represents an objective and reproducible measurement that requires only the input of the variable of price movement.

Implied volatility is to be distinguished from the mechanical precision of historical volatility.  Implied volatility is the nexus point at which the raw emotions of the human brain so evident in trading meet the mathematical precision of the historical volatility. Of the three primal forces impacting option price, implied volatility is the only factor subject to cerebration. As a malleable and subjective input factor, it is reflective of both general market sentiment and the subjective evaluation of potential future volatility and direction of the specific underlying. As such, it is a forward-looking evaluation as opposed to historical volatility which is well, historic.

While this distinction may seem arcane and of academic interest only, it is decidedly not. Failure to consider the current position of implied volatility will routinely negatively impact trades and is the most frequent cause of paradoxical behavior of option prices.

July 23, 2010

Where’s the Pony?

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 12:20 pm

Time to expiration, price of the underlying, implied volatility, historical volatility, puts, calls, delta, gamma, theta, vega, in the money, at the money, out of the money, intrinsic value, extrinsic value, higher commissions, egregious bid ask spreads, no options traded on a stock with a beautiful technical set up, multiple potential beasts and physiologies, LEAPS; why would one even bother with options?  If I retain a shred of rationality, an open question to be sure, there must be some reason to complicate my life with these additional variables.

Ronald Reagan was fond of making a point with the story of the 8 year old boy who while visiting his grandfather’s farm fell into a pile of horse manure.  When his father found him a short while later, the boy was smiling ear-to-ear and happily shoveling away the muck.  When asked why, the son replied: “With this much poop, there must be a pony in here somewhere.”  Option trading is gaining popularity because the pony hidden beneath the pile of muck is (drum roll please): risk control.

Traders new to options often incorrectly focus on the ability to leverage positions, but in his classic summarization of this approach Jared Woodard opines:

But leverage, as anyone who’s followed the fate of the investment banks knows, is just a means for magnifying outcomes.  A leveraged risk-taker will experience more glorious wins and more disastrous losses, like a deranged person who shouts both poetry and obscenities (instead of whispering them quietly to himself, like the rest of us).

There are other logical and valid reasons for using options as one’s investment vehicle of choice to be sure, but the singular advantage of options is risk control.

Bill Burton,

Writer, Market Taker Mentoring LLC