What Is Historical Volatility (HV)?
Historical volatility (HV) is a statistical measure of the dispersion of returns for a given security or market index over a given period of time. Generally, this measure is calculated by determining the average deviation from the average price of a financial instrument in the given time period. Using standard deviation is the most common, but not the only, way to calculate historical volatility. The higher the historical volatility value, the riskier the security. However, that is not necessarily a bad result as risk works both ways - bullish and bearish.
Understanding Historical Volatility (HV)
Historical volatility does not specifically measure the likelihood of loss, although it can be used to do so. What it does measure is how far a security's price moves away from its mean value.
For trending markets, historical volatility measures how far traded prices move away from a central average, or moving average, price. This is how a strongly trending but smooth market can have low volatility even though prices change dramatically over time. Its value does not fluctuate dramatically from day to day but changes in value at a steady pace over time.
This measure is frequently compared with implied volatility to determine if options prices are over- or undervalued. Historical volatility is also used in all types of risk valuations. Stocks with a high historical volatility usually require a higher risk tolerance. And high volatility markets also require wider stop-loss levels and possibly higher margin requirements.
Aside from options pricing, HV is often used as an input in other technical studies such as Bollinger Bands. These bands narrow and expand around a central average in response to changes in volatility, as measured by standard deviations.
Using Historical Volatility
Volatility has a bad connotation, but many traders and investors can make higher profits when volatility is higher. After all, if a stock or other security does not move it has low volatility, but it also has a low potential to make capital gains. And on the other side of that argument, a stock or other security with a very high volatility level can have tremendous profit potential but at a huge cost. It's loss potential would also be tremendous. Timing of any trades must be perfect, and even a correct market call could end up losing money if the security's wide price swings trigger a stop-loss or margin call.
Therefore, volatility levels should be somewhere in the middle, and that middle varies from market to market and even from stock to stock. Comparisons among peer securities can help determine what level of volatility is "normal."