What Does Volatility Mean to Stock and Option Traders?
optionsguy posted on 08/24/10 at 12:11 PM
Edited by optionsguy at 10/06/10 at 05:13 PM
Hello, I’m Brian Overby, Senior Options Analyst at TradeKing, and author of The Options Playbook.
I have a question actually submitted today that I would like to address, and the question is: What does the term “volatility” mean to both stock and option traders?
That’s a very solid question. Volatility is one of those concepts that is often misunderstood. A lot of beginning traders think they don’t need to understand it, and it’s a concept that, I think if you’re going to trade options, you must understand, and it’s one of these things that you should definitely know if you’re going to trade stocks.
So, ultimately there are two different forms of volatility; one is historical and one is called implied. “Historical” pertains specifically to stock prices; it’s what’s happened in the past. The textbook definition of historical volatility is: The annualized standard deviation of stock price movement.
Now, a big word in there is that it’s annualized. Usually, if you see a volatility that is quoted, it usually is based off of a one-year period. Now, you can see many different volatilities, every once in a while you’ll see 30-day or 40-day historical volatility, and when you see that, that’s because it’s based on that time period, thirty or forty days. But in the textbook, it basically says it is a one-year period unless stated otherwise.
Now, what is volatility? Well, volatility is actual price fluctuation. We’re looking at the highs and lows, day in and day out, throughout the entire year. Now, stocks can be very volatile. You can have, for example, a stock that started at $100, and at the end of the year finished at $100, but in the middle it traded as high as $250 and as low as $25. Bottom line is, where the price is at the beginning of the year versus the end of the year doesn’t really necessarily mean that the stock is volatile or not. It’s all about how big were the price swings during that time period.
Okay, now implied kind of feeds off of historical, if you will. This is actually a term that comes directly from the options marketplace. Implied is what the options marketplace is “implying” the stock volatility to be in the future, or, another way to say it, over the life of an option contract.
Now, implied volatility comes directly from the option. As a matter of fact, if there are no options trading on an underlying stock or index, there will be no way to calculate the implied volatility. So this implied volatility is actually – one thing that I really like about implied is, it’s taking in all the market forces that are at play. So if a company’s coming up with earnings, if there’s a major other news event, Phase III trials on a pharmaceutical company, usually the trading environment knows this, and it will imply more volatility going forward, and that number is actually taken out of the price of the option contract.
So, I might have a historical volatility going back that might be as low as twenty-five or thirty percent, and oftentimes you might see an implied volatility be quite a bit higher, or quite a bit lower, based off of the fact that going forward in time there’s a major news event, or maybe there’s absolutely nothing going on in the marketplace at all. But the big thing to know about the difference between historical and implied volatility, historical, it has already happened, it’s all based off of previous movement in the stock; implied is totally based on what the marketplace is implying going forward.
All right, my name is Brian Overby, I am Senior Options Analyst at TradeKing, and author of The Options Playbook. If you would like to learn more, please visit us at tradeking.com, and check out our Trader Network, where traders network and share actual trades and performance. Also, there’s an education center there where you can check out a plethora of information on all aspects of investing.