Dave draws off his years of experience as a Financial Advisor and Analyst to teach others all about finance and the investing world.
Two Important Types of Price Volatility
When trading options, there are two types of price volatility traders need to understand. The two types are historical volatility and implied volatility. As the name implies, historical volatility measures how volatile a stock has been in the past. Since volatility is a fancy way of saying the range of a stock, measuring the historical volatility of a stock takes a little bit of Statistics 101 to figure out.
The easiest way to measure historical volatility is first to measure the standard deviation over a set period of time for the stock you are looking at. Then you divide the stock price by the standard deviation to get the historical volatility expressed as a percentage. Standard deviation is a statistical calculation that indicates the extent of deviation within a group or a data set. In this case, it's a great way to gauge how much a stock bounces around different values.
Think of a bag of marbles on a gym floor. If you gently roll out the marbles, they'll stay within a small area. In terms of deviation from the average location, this would have a small standard deviation. If you came in and spiked the open bag of marbles on the ground, the marbles would bounce all over the place and have a huge standard deviation. You can think of the locations all over the floor as a stock's closing prices over several days. If the stock trades all over the place, it will have a higher standard deviation of closing prices and therefore a high measure of historical volatility.
Implied volatility is a forward-looking measure of volatility. Rather than look at the movement a stock has had in the past, implied volatility attempts to quantify how much it will move in the future. This becomes especially relevant when trying to gauge the price of an option. Thinking back to our marble metaphor, implied volatility would be guessing how far apart the next bag of marbles would get spread across the gym floor.
One of the most important factors in implied volatility is event risk.Event risk occurs when there is a macroeconomic or company-specific event in the future which can positively or negatively impact a stock's price. Options will often have greater implied volatility when major stock events are on the horizon. Every three months when earnings season comes along, implied volatility in equity options increases. Just before a company's earnings report, their options have increased implied volatility. After the report has been released and the stock trades the next day, some of the implied volatility is removed from the stock's options.
Options traders will compare historical volatility to implied volatility in order to help decide whether an option is overpriced, underpriced, or appropriately priced. If implied volatility seems too high, traders will employ strategies which look to sell volatility. If they believe implied volatility is too low, then they will look to buy volatility.
- Historical volatility measures how volatile a stock has been in the past.
- Implied volatilityis a forward-looking measure of volatility that attempts to quantify the future movement of a stock other financial instrument.
- Standard deviationis a statistical calculation that indicates the extent of deviation within a group or a data set.
- Event riskoccurs when there is a macroeconomic or company-specific event in the future which can positively or negatively impact price.
Traders compare historical and implied volatility in order to uncover short-term trading opportunities to exploit to make profits.
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