Implied Volatility vs. Historical Volatility: An Overview
Volatility is a metric that measures the magnitude of the change in prices in a security. Generally speaking, the higher the volatility—and, therefore, the risk—the greater the reward. If volatility is low, the premium is low as well. Before making a trade, it's generally a good idea to know how a security's price will change and how quickly it will do so.
In an options trade, both sides of the transaction make a bet on the volatility of the underlying security. Even though there are several ways to measure volatility, options traders generally work with two metrics: Implied volatility and historical volatility. Implied volatility accounts for expectations for future volatility, which are expressed in options premiums, while historical volatility measures past trading ranges of underlying securities and indexes.
The combination of these metrics has a direct influence on options' prices—specifically, the component of premiums referred to as time value, which often fluctuates with the degree of volatility. Periods when these measurements indicate high volatility generally tend to benefit options sellers, while low volatility readings benefit buyers.
Below, we've outlined what each metric is and some of the key differences between the two.
- Implied or projected volatility is a forward-looking metric used by options traders to calculate probability.
- Implied volatility, as its name suggests, uses supply and demand, and represents the expected fluctuations of an underlying stock or index over a specific time frame.
- With historical volatility, traders use past trading ranges of underlying securities and indexes to calculate price changes.
- Calculations for historical volatility are generally based on the change from one closing price to the next.
Implied volatility, also known as projected volatility, is one of the most important metrics for options traders. As the name suggests, it allows them to make a determination of just how volatile the market will be going forward. This concept also gives traders a way to calculate probability. One important point to note is that it shouldn't be considered science, so it doesn't provide a forecast of how the market will move in the future.
Unlike historical volatility, implied volatility comes from the price of an option and represents its volatility in the future. Because it is implied, traders can't use past performance as an indicator of future performance. Instead, they have to estimate the potential of the option in the market.
Investors and traders can use implied volatility to price options contracts.
By gauging significant imbalances in supply and demand, implied volatility represents the expected fluctuations of an underlying stock or index over a specific time frame. Options premiums are directly correlated with these expectations, rising in price when either excess demand or supply is evident and declining in periods of equilibrium.
The level of supply and demand, which drives implied volatility metrics, can be affected by a variety of factors ranging from market-wide events to news related directly to a single company. For example, if several Wall Street analysts make forecasts three days before a quarterly earnings report that a company will soundly beat expected earnings, implied volatility and options premiums could increase substantially in the few days preceding the report. Once the earnings are reported, implied volatility is likely to decline in the absence of a subsequent event to drive demand and volatility.
Also referred to as statistical volatility, historical volatility gauges the fluctuations of underlying securities by measuring price changes over predetermined periods of time. It is the less prevalent metric compared to implied volatility because it isn't forward-looking.
When there is a rise in historical volatility, a security's price will also move more than normal. At this time, there is an expectation that something will or has changed. If the historical volatility is dropping, on the other hand, it means any uncertainty has been eliminated, so things return to the way they were.
This calculation may be based on intraday changes, but often measures movements based on the change from one closing price to the next. Depending on the intended duration of the options trade, historical volatility can be measured in increments ranging anywhere from 10 to 180 trading days.
By comparing the percentage changes over longer periods of time, investors can gain insights on relative values for the intended time frames of their options trades. For example, if the average historical volatility is 25% over 180 days and the reading for the preceding 10 days is 45%, a stock is trading with higher-than-normal volatility. Because historical volatility measures past metrics, options traders tend to combine the data with implied volatility, which takes forward-looking readings on options premiums at the time of the trade.
In the relationship between these two metrics, the historical volatility reading serves as the baseline, while fluctuations in implied volatility define the relative values of options premiums. When the two measures represent similar values, options premiums are generally considered to be fairly valued based on historical norms. Options traders seek the deviations from this state of equilibrium to take advantage of overvalued or undervalued options premiums.
For example, when implied volatility is significantly higher than the average historical levels, options premiums are assumed to be overvalued. Higher-than-average premiums shift the advantage to options writers, who can sell to open positions at inflated premiums indicative of high implied volatility levels. Under these circumstances, the objective is to close positions at a profit as volatility regresses back to average levels and the value of options premiums declines. Using this strategy, traders intend to sell high and buy low.
Options buyers, on the other hand, have an advantage when implied volatility is substantially lower than historical volatility levels, indicating undervalued premiums. In this situation, a return of volatility levels to the baseline average can result in higher premiums when options owners sell to close positions, following the standard trading objective of buying low and selling high.