Implied Volatility and Past Volatility: Overview
Volatility is a measure of how much a security’s price changes. Generally speaking, the higher the volatility, the higher the risk, the higher the reward. The lower the volatility, the lower the premium. Before making a transaction, it is generally a good idea to know how the price of a security changes and how quickly it changes.
- Implicit or predicted volatility is a positive indicator that options traders use to calculate probabilities.
- Implied volatility, as the name implies, uses supply and demand to represent the expected fluctuations in a stock or index over a particular time frame.
- Due to past volatility, traders use the historical trading range of the underlying security and index to calculate price fluctuations.
- Past volatility calculations are usually based on changes from one closing price to the next.
In options trading, both sides of the transaction bet on the volatility of the underlying security. There are several ways to measure volatility, but option traders typically use two indicators: implied volatility and historical volatility. Implied volatility describes the forecast of future volatility expressed in option premiums, while historical volatility measures the historical trading range of underlying securities and indexes.
The combination of these indicators has a direct impact on the option price. Specifically, it is a premium element called time value, which often fluctuates depending on the degree of volatility. Periods when these measurements show high volatility generally tend to benefit the seller of the option, while low volatility measurements benefit the buyer.
Below is an overview of what each metric is and some of the main differences between the two.
Implied volatility, also known as predictive volatility, is one of the most important indicators for options traders. As the name implies, it allows them to determine how volatile the market will be. This concept also provides traders with a way to calculate probabilities. One important point to note is that it should not be considered a science and therefore does not provide a prediction of how the market will move in the future.
Unlike past volatility, implied volatility derives from the price of the option and represents future volatility. As implied, traders cannot use past performance as an indicator of future performance. Instead, they need to estimate the potential options in the market.
Investors and traders can use implied volatility to price option contracts.
By measuring a significant imbalance between supply and demand, implied volatility represents the expected fluctuations in the stock or index over a particular time frame. Option premiums are directly correlated with these expectations, with prices rising when either excess demand or supply becomes apparent and falling during the equilibrium period.
The level of supply and demand that drives implied volatility indicators can be influenced by a variety of factors, from market-wide events to news directly related to a single company. For example, if some Wall Street analysts predict that a company will significantly exceed its projected earnings three days before its quarterly earnings report, implied volatility and option premiums could increase significantly a few days before the report. I have. Once revenue is reported, implied volatility can decline in the absence of subsequent events that drive demand and volatility.
Volatility of the past
Past volatility, also known as statistical volatility, measures fluctuations in the underlying security by measuring price fluctuations over a period of time. This is a less popular indicator compared to implied volatility, as it is not future-proof.
As volatility in the past rises, the price of securities also fluctuates more than usual. At this point, something will change or is expected to change. On the other hand, if the volatility of the past has declined, it means that the uncertainty has been eliminated and the situation will return to its original state.
This calculation may be based on changes during the day, but often measures movement based on changes from one closing price to the next. Historical volatility can be measured in increments ranging from 10 to 180 trading days, depending on the intended duration of options trading.
By comparing the rate of change over time, investors can gain insight into the relative value of the intended time frame for options trading. For example, if the average past volatility for 180 days is 25% and the reading for the last 10 days is 45%, the stock is trading at a higher volatility than usual. Options traders tend to combine data with implied volatility because historical volatility measures historical indicators. Implied volatility provides a future outlook for option premiums at the time of trading.
In the relationship between these two indicators, past volatility readings serve as the baseline, and implied volatility fluctuations define the relative value of the option premium. If the two indicators represent similar values, the option premium is usually considered to be fairly valued based on historical criteria. Options traders are seeking deviations from this equilibrium in order to take advantage of overvalued or undervalued option premiums.
For example, if the implied volatility is significantly higher than the historical average level, the option premium is considered overvalued. Higher than average premiums shift the advantage to option writers. Option writers can sell to open positions with Implied Premium, which indicates a high level of implied volatility. In these situations, the goal is to make a profit and close the position as volatility returns to average levels and the value of option premiums declines. Using this strategy, traders sell at high prices and buy at low prices.
On the other hand, option buyers have an advantage when implied volatility is significantly lower than past volatility levels, indicating that the premium is undervalued. In this situation, when the volatility level returns to the baseline average, the premium can be higher when the option owner sells to close the position.