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Aug 11, 2015

Implied and Historical Volatility

By:Sage Anderson

Today on the blog we are putting some key volatility concepts under the microscope, specifically as featured on the tastytrade program The Skinny on Options Math.

Volatility is a key component in calculating equity derivatives prices. The volatility of a stock represents the variability of the stock's returns over time. In lay terms, volatility essentially tells us how a stock's price has fluctuated in the past.

While we can measure a stock's past movement (historical volatility), nobody knows the future movement of a stock's price. That means that the market produces an implied estimate for future volatility baked into the current market price of options.

This value, called "implied volatility," is therefore the price of an option observed in the market at any given point in time.

In several recent episodes, The Skinny on Options Math team featured the nuts and bolts of implied volatility. The goal in these sessions was to break what can often seem like a daunting concept into manageable pieces.

Referenced in these episodes, as well as in a lot of other tastytrade content, are the terms implied volatility, historical volatility, and future volatility.

As stated above, implied volatility is reverse-engineered from current option prices. Historical volatility is an exact figure derived from how much a stock has moved in history. Future volatility is an estimate of what volatility will be in the future.

So historical volatility is a fact of history, implied volatility is observable in the current market, and future volatility estimates vary widely based on the assumptions used to calculate it.

One previous segment of The Skinny on Options Math was dedicated completely to implied volatility and we encourage you to view that entire episode to gain the best possible understanding of how this number is calculated and some important things to keep in mind when interpreting it.

In simplified terms, implied volatility is the market’s expectation for a stock price’s movement over a given period of time (present through expiration).

In another episode of The Skinny on Options Math, the gang presents a comparison between implied volatility and historical volatility. Their discussion produces added depth and perspective on each concept.

One of the most important takeaways from this session is the fact that historical volatility is unambiguous. A stock has moved an exact amount per day since it was issued and that value can be measured. While implied volatility can be observed in the market, there are some assumptions that go into reverse engineering this value, and accordingly, different traders may utilize a slightly different number in their trading models and platforms.

Another quick aspect pointed out during this session is that as long as one is consistent in calculating and applying an implied volatility value, these very subtle differences are largely negligible.

The team furthermore explains why historical volatility is not used in place of implied volatility, as illustrated below:

Reviewing these episodes will certainly improve your understanding of these critical concepts in options trading. If you would like to continue your investigation into these volatility concepts, click the "Learn" tab on the front page of the tastytrade website, or simply follow this link.

The entire library of content from The Skinny on Options Math can be accessed by following this link.

We greatly value your involvement in the tastytrade community and wholeheartedly encourage you to provide us with feedback in the comments section below if you have any questions or suggestions.

Happy trading!

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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