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In its most basic form, volatility means change. Implied volatility is best calculated with the aid of a computer that can easily apply current market prices in the model. This process provides the trader with market consensus for expected volatility in the future.

A trader can gain quick insight to a stock's historical volatility by looking at its price range; the bigger the range, the higher its volatility. The formula for calculating historical volatility is somewhat complex; however, an approximate value can be obtained by using the price range for a stock over a relatively short period (anywhere from 10 days to 12 months). To determine a stock's historical volatility, calculate the equilibrium level (midpoint) of a stock's price range. Then simply divide the difference between the high point and the equilibrium level by the equilibrium level to get the volatility percentage. For example, Microsoft Corporation has been fluctuating between 22 (support) and 28 (resistance) for the last year. The equilibrium level is 25 [(28-22) / 2 = 3 and 28-3 = 25]. Microsoft's approximate volatility is 12% [3 / 25 = 12%]. This percentage can then be used to forecast the maximum price action a stock is likely to make throughout the next 12 months.

Examining the difference between a stock's historical volatility and implied volatility can also help traders to recognize when a stock option is underpriced or overpriced. If the option's implied volatility is higher than the historical volatility, the option is theoretically overpriced. Option sellers look for these kinds of opportunities to sell high and buy low. In contrast, option buyers look for underpriced options by searching for market situations in which the implied volatility of an option is lower than the historical volatility (buy low and sell high). You may choose to spend a lot of time screening markets to determine their volatility. In general, there are two very different kinds of markets. The first one has plenty of movement, and high volatility. The second market has very low volatility. In general, sell options with high volatility and buy options with low volatility.

Related Articles:

• Using Volatility to Select Option Strategies
• Understanding the Different Shapes of Implied Volatility
• Using Historical Volatility
• Option Strategies for High IV Markets
• Understanding Options Volatility
• Taking Advantage of a Low Implied Volatility Environment
• Using Historical Volatility in the Equity Markets
• Letting Volatility Drive Options Positions
• Trading In a High Implied Volatility Environment

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