HISTORICAL VOLATILITY AND IMPLIED VOLATILITY
We know Historical Volatility is calculated by measuring the stocks past price movements. It is a known figure as it is based on past data. I want go into the details of how to calculate HV, as it is very easy to do in excel. The data is readily available for you in any case, so you generally will not need to calculate it yourself. The main point you need to know here is that, in general stocks that have had large price swings in the past will have high levels of Historical Volatility. As options traders, we are more interested in how volatile a stock is likely to be during the duration of our trade. Historical Volatility will give some guide to how volatile a stock is, but that is no way to predict future volatility. The best we can do is estimate it and this is where Implied Vol comes in.
- Implied Volatility is an estimate, made by professional traders and market makers of the future volatility of a stock. It is a key input in options pricing models.
- The Black Scholes model is the most popular pricing model, and while I won’t go into the calculation in detail here, it is based on certain inputs, of which Vega is the most subjective (as future volatility cannot be known) and therefore, gives us the greatest chance to exploit our view of Vega compared to other traders.
- Implied Volatility takes into account any events that are known to be occurring during the lifetime of the option that may have a significant impact on the price of the underlying stock. This could include and earnings announcement or the release of drug trial results for a pharmaceutical company. The current state of the general market is also incorporated in Implied Vol. If markets are calm, volatility estimates are low, but during times of market stress volatility estimates will be raised. One very simple way to keep an eye on the general market levels of volatility is to monitor the VIX Index.
WHY IS VOLATILITY IMPORTANT?
One of the main reasons for needing to understand option volatility, is that it will allow you to evaluate whether options are cheap or expensive by comparing Implied Volatility (IV) to Historical Volatility (HV).
EXPECTING AN INCREASE IN IMPLIED VOLATILITY
What strategies will benefit from an increase in implied volatility with all other factors remaining the same?
Long Call
Long Put
Long Straddle
Long Strangle
Bull Call Spread
Bear Put Spread
Short Iron Condor
Short Butterfly
Ratio Backspreads
EXPECTING A DECREASE IN IMPLIED VOLATILITY
What strategies will benefit from a decrease in implied volatility with all other factors remaining the same?
Short Call
Short Put
Short Straddle
Short Strangle
Bull Put Spread
Bear Call Spread
Long Iron Condor
Long Butterfly
Ratio Spreads
