You've probably heard volatility is an important factor for active traders. But do you really understand it - or know how to apply to your trading decisions?

I've heard a lot of misconceptions about volatility from traders over the years. This post begins a series that will explain volatility in a way you can really understand and use, give some practical examples, and show you how to use TradeKing's extensive toolset to factor volatility into your trading.

If you're reading this, thinking volatility is only for options traders -- that's probably the biggest misconception. In fact, it's informative both stock and options traders alike.

Today's post covers the basics: what is volatility?

It's a measure of past movement that can provide insight into possible future movements of a stock or index. Volatility doesn't point to a direction for that movement, but it can tell you how likely it is that a given security will reach a specific price point.

While there are many different types of volatility, as a retail trader you really only need to think about two forms: historical volatility and implied volatility.  "Historical volatility" is defined in textbooks as the annualized standard deviation of past stock price movements. In layman's terms, it's a measure of the daily price fluctuations of a security over a year.

"Implied volatility" is what the marketplace is "implying" the volatility of the underlying security to be in the future.  The implied volatility number is derived from the options price. If no options trade in a security, then naturally there is no implied volatility for that security. Implied volatility is the only variable in an options premium that is not directly observable -- but it acts as a critical surrogate for option value.

For your purposes, implied volatility is probably more important than historical. We concentrate on implied because the marketplace usually knows all. If the underlying security is announcing earnings or there is going to be a major court ruling, it shows up in the implied volatility for options that will expire in the month the news occurs.  In other words, implied volatility can help you gauge how much a bit of news or other development will swing a security.

But the real question is: How do you calculate implied volatility? And how can we use this number to make smarter trading decisions?  Stay tuned...

Regards,
Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility there is no guarantee that this forecast will be correct.