Volatility - Part II

In the last post we discussed Historical and Implied Volatility.  It's time now to see how these two important indicators can be used to help increase our probabilities of a successful trade.

For this discussion, we are going to treat HV and IV as the surrogate projection of the stock and option price respectively.  We are also going to use a website that is well known for volatility information - www.ivolatility.com.

 After going into www.ivolatility.com and entering the underlying symbol of the stock, two choices of graphs appear on the right hand side and the bottom graph is the Volatility graph.  The blue line is the 30 Day HV and the yellow line is the IV.  We read the chart on the right and it becomes important to understand where the lines should be to be in a "sweet spot" for various trading strategies.

If, for example, the IV is at 68%, we read this as that the Option is priced for a 68% move, up or down, in the underlying stock.

Now, we look at the position of the HV and IV on the right hand side of the chart.  The following graphic illustrates how for a Call Option, the HV should be below the mid-point and the IV should be below the midpoint.  If the stock is undervalued, then the probabilities of it going up are greater, and if the option is undervalued, then the price is right for the Call Option that is purchased.

So, in this particular chart, volatility is acceptable for a Call Option.  In the next post, we will look at the volatility requirements for both the Put Option and the Covered Call.

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.