BACK TO BASICS: Using Historical Volatility
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June 27, 2005
To be an effective options strategist it is paramount that the concept of volatility is clearly understood. There are two types of volatility present in the options market: one is implied volatility and the other is statistical volatility (or more commonly known as historical volatility). Implied volatility is a measure of the underlying stock’s volatility as reflected in an option’s price. Historical volatility is computed using past stock prices and is calculated by using the standard deviation of a stock’s price changes from close to close of trading going back a specified number of days.
Typically, historical volatility is not publicized as much as implied volatility; however, it is an important factor to consider since it measures the stock’s tendency for movement. This type of information helps determine an option’s true worth. For example, high or low historical volatility provides the option strategist key information on what type of strategy can best be implemented to optimize profits in a particular market.
Usually when a stock or index trades all over the board, its historical volatility will increase. On the other hand, there are periods of time when stocks or indexes move sideways and show low levels of historical volatility. Basically historical volatility can be used to measure whether an underlying equity has been trading quietly and in a narrow range, or erratically with large price swings.
Even though historical volatility measures past prices, it provides little if any information about what will transpire in the future. The trader must keep in mind that historical volatility is constantly in a state of flux. Though it is possible to assign a value to the past performance of a stock or index, it is impossible to forecast whether the same levels will recur in the future.
As an options strategist you must take into account the dynamic nature of historical volatility as well as being aware of unusual events. For example, if a trader analyzed the historical volatility of the Dow Jones Industrial Average in September of 1987, they would be way off in their estimate of volatility since it included only closing prices through September of that year and did not account for the unusual event that was about to take place. “Bloody Monday,” or the stock market crash in October of that year, led to a sharp increase in volatility.
In addition, when there is an unusual event it causes a spike in historical volatility that is not sustainable. This is why historical volatility is best evaluated over different time frames and recognizes the impact of unusual occurrences, such as panics, earnings surprises and other unexpected events. Option strategists need to consider historical volatility over various time frames and make a determination as to what is normal for that particular equity.
For instance, when considering an average true value of historical volatility over a period of time, unusual periods of high or low volatility become more obvious. When trading historical volatility there is an important concept to understand, which is reversion to the mean. Basically when volatility diverges greatly from the normal range, there is a propensity for it to revert back to that average, or mean. Historical volatility allows option strategists to estimate the normal range and to locate deviations from the mean to construct profit-generating strategies.
Happy Trading.
Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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