Monday, March 15, 2010

Volatility - Part I

One of the most important aspects of the trading process is understanding and using Volatility.  There are two types of Volatility that we will explore over the next few posts: Historical Volatility (HV) and Implied Volatility (IV).

Historical Volatility (HV) is the realized volatility of a financial instrument over a given time period.  Generally, this measure is calculated by determining the average deviation from the average price of a financial instrument in the given time period.  Standard deviation is the most common but not the only way to calculate historical volatility.  Also known as "statistical volatility,"  this measure is frequently compared with implied volatility to determine if options prices are over- or undervalued.

Now, with the legal definition out of the way, let's take a look at a simplified view of HV.  HV is simply how much the underlying (Stock) changes in price.  It is usually calculated by taking the daily closing prices and averaging how much change is occurring over a given period of time. 

The Option Chain within MachTrader has the HV and IV information at the top (as shown by the red box).  For the HV, this gives the Historical Volatility within that specific time frame.

Implied Volatility (IV) is the estimated volatility of a security's price.  In general, implied volatility increases when the market is bearish and decreases when the market is bullish.  This is due to the common belief that bearish markets are more risky than bullish markets.

In addition to known factors such as market price, interest rate, expiration date, and strike price, implied volatility is used in calculating an option's premium.  IV can be derived from a model such as the Black-Scholes Model.

Now - the simplified version:  Implied Volatility of an option represents what traders expect to happen in the future of the stock and how volatile they expect it to become.  In other words, it is the volatility of the future.  The IV is the surrogate projection of an Option's price. 

Next post we will explore how to use the HV and IV to determine if the Volatility is in a "sweet spot" to trade Calls, Puts or Covered Calls.