Types Of Volatility
Volatility measures the magnitude of the change in prices in a security. In an options trade, both sides of the transaction make a bet on the volatility of the underlying security. There are a number of ways to measure volatility, but the two most useful ones are:
- Historical Volatility (HV).
- Implied volatility (IV).
Historical volatility uses the historical data of the security for the computation of the trading range while Implied Volatility accounts for expectations for the future volatility.
It gauges the fluctuations of a stock by measuring changes in price over a stipulated period of time. It is less prevalent than IV because it doesn’t give a sneak peek into the future.
When there is a rise in HV, a security’s price will also move more than normal. At this time, traders expect that something will change or has changed. If the HV on the other hand is dropping, it means any uncertainty has been eliminated, so things may run as smooth as they were. Because HV measures past data, traders tend to combine the data with IV at the time of trades.
Implied Volatility (IV) is simply an estimate of the future volatility of a stock based on options prices. It gives traders a way to comprehend just how volatile the market will be in the near future. Investors and traders can use IV to price option contracts. Options premium are directly correlated to the volatility expectations. When volatility is expected to be high in future, the option premium will be relatively expensive, whereas if in future, a lower volatility is expected, an option will have relatively low premium.
IV generally increases when there is an event or announcement coming up, and it has a tendency to decrease after that announcement or event has passed. So you may want to factor this in analyzing an option’s IV, especially for options that are close to expiry.
When IV is significantly higher than the average historical levels, options premium are assumed to be overvalued. These options are advantageous to option sellers. In such situations, the objective is to square off positions and pocket profit as volatility slides down to average levels and the option premium declines. Option buyers on the other hand, have an advantage when the IV is significantly lower than the HV, indicating undervalued options premium.