Four Things You Need to Know About Volatility

There is volatility in the market, more so now than usual. Are you prepared to trade and profit from that volatility? Before you place another trade, make sure you know these Four Things Every Trader Must Know about Volatility.

All Option Trades Have a Volatility Component

Every option trade involves volatility exposure in one way or another. While it’s intuitive for most traders that each trade usually involves a bullish or bearish directional stance, many overlook the fact that they are taking on a bullish or bearish volatility position too. Therefore, the trader needs to strive to buy volatility cheaply and sell it when it’s expensive. But this is easier said than done. To understand all that goes into analyzing volatility, let’s first review the two types of volatility.

Historical Volatility

Historical volatility (also called realized volatility or statistical volatility and often designated by “HV”) is the actual volatility realized by the underlying security, measured in terms of the magnitude of recent price movement. Specifically, HV is the annualized standard deviation of an asset. This figure is stated as a percentage of the asset price. Even to non-option traders, HV is a helpful guide to comparing the volatility of a stock with another stock or itself over time. For example, a stock with a 20 percent HV is less volatile than one with a 40 percent historical volatility. Also a stock with a current HV of 50 percent is more volatile than it was if its HV was 30 percent at some time in the past.

Implied Volatility

While HV looks back at actual asset prices, implied volatility (or “IV”) looks forward. IV is generally interpreted as the market’s consensus expectation for the future volatility of an asset. This figure is also stated in percentage terms and can be derived from the price of an option. Specifically, it is the expected future volatility of the underlying, implied by the price of its options. For example, a stock with a 20 percent IV is expected (by the market as a whole) to experience less volatility than a stock with a 40 percent IV. The IV of an asset can also be compared with itself over time. For example, if a stock currently has an IV of 50 percent versus 30 percent in the past, the market now expects the stock to be more volatile than it previously did.

Analyze Volatility Charts

The common application of volatility data is studied by use of a volatility chart. A volatility chart tracks the volatility “level” over time for both HV and IV. It is a helpful visual aide because it makes it easy to compare HV with IV both currently and over time. Though these are helpful aides, they are often misinterpreted by novice traders with unfortunate consequences. Volatility charts are one area where knowing just enough to be dangerous can be, well, dangerous.

Traders must perform three separate analyses

First, compare current IV with current HV. This gives an indication of how the market is pricing volatility into option prices in comparison with recent stock volatility. If the two are significantly different, an opportunity may exist to buy or sell volatility at a favorable level. Generally, if IV is above HV this is the first indication that option prices may be high. Likewise, if IV is below HV, this may mean option prices are cheap.

But to be sure, traders must also compare current IV with past IV. This helps a trader understand whether IV is comparatively high or low in relative terms. If implied volatility is higher than normal it may be expensive, warranting a sale; if it is lower than normal it may be a cheap buy.

Finally, traders need to complete their analysis by also comparing current HV with past HV. HV on the volatility chart can give an indication as to whether recent stock volatility has been greater or lower than normal. If current HV is higher than it was on average in the past, the stock is showing that it is more volatile than normal.

If the price at which an option can be traded (in terms of IV) doesn’t support the higher stock volatility, the trader must trade accordingly. That is, if IV is very low, as HV is higher than normal, it may be a buy signal.

Conversely, if HV has fallen below normal levels, traders need to observe IV to see if an opportunity to sell volatility exists. If IV is high in this HV setup, it could be a volatility sell signal.

Wrap Up

Certainly, volatility analysis is both an art and a science. This article has shown the basics for analyzing volatility. But there are a seemingly infinite series of permutations of how implied volatility and historical volatility can interact. Each volatility scenario is unique. Having a deep understanding of volatility combined with experience from putting that knowledge into practice can help traders use volatility to their advantage, and make smarter trades.

Dan Passarelli