BACK TO BASICS: Using Historical Volatility in the Equity Markets
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August 7, 2006
No matter what particular technical study or indicator is used for viewing historical volatility, it is essential to keep in mind that it is much like trying to drive a car forward while looking in the rear view mirror. Basically, while historical volatility gauges past prices, it provides little indication about what will happen in the future. Also, keep in mind that volatility is constantly changing.
Given the changing and dynamic nature of historical volatility, the options strategist must take into account unusual events. For example, if a trader examined the historical volatility of the Dow Jones Industrial Average ($INDU) in late September 1987, they would be greatly underestimating volatility because it only includes closing prices through September of that year. The subsequent stock market crash led to a sharp and immediate increase in volatility.
This event, of course, was definitely unusual, and when there is a unique and unusual event, it can cause a spike in historical volatility that is not sustainable. Therefore, in analyzing historical volatility, it is also important to consider different time frames and acknowledge the impact of unusual occurrences, such as panics, earnings surprises and other unexpected events.
Options strategists must look at historical volatility over different time frames and then make a determination as to what is normal for a particular underlying asset. By considering an average of historical volatility over a period of time, unusual periods of high or low volatility become more obvious.
For example, if the average volatility of stock XYZ is 29 percent, but over the past 10 days it increases to 64 percent then the large increase warrants investigation. The trader needs to figure out what caused the large increase in volatility. It could have been an earnings announcement, a takeover attempt, a new product release, an accounting irregularity or some other one-time event. Regardless of the nature of the event it is critical that the trader understand it before entering a position.
In trading historical volatility, there is an important concept to understand, which is called reversion to the mean. In other words, although historical volatility is always in a state of flux, most stocks or indexes can be assigned a normal or average value. When volatility diverges greatly from that normal range, there is a tendency for it to revert back to that average or mean.
Historical volatility enables the options strategist to approximate the normal range and to find deviations from the mean for developing profit generating trading opportunities. This is why understanding historical volatility is critical to the long-term success of the options strategist.
Happy Trading.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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Listen to Jeff at www.ProfitStrategiesRadio.com
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