Historical volatility is a measure of how much the underlying asset has been moving in the past.

Implied volatility is a function of an option's price and is backed out from the price.

Implied volatility shows the expectation of future volatility.

Volatility is a one-standard-deviation annual figure.

Volatility charts are invaluable for getting an idea of the relative value of an option.

Using both historical and implied volatility is helpful.

Buy low and sell high. Or, for directional option traders, spread high (use spreads on high implied volatility).

All option traders are volatility traders, whether they realize it or not. Volatility is the key factor both in option pricing and in the profitability of any options trade. A call buyer is not just bullish, but is also betting that the volatility of the stock will be more than that priced into the call. A covered call seller is betting that the volatility of the stock will be less than that implied by the option. So it is very important to understand volatility data to be a successful options trader.

Types of Volatility

There are several types of volatility. The first is the actual volatility of the stock. This is seen in the historical volatility, which can be measured over any time frame but usually gauged in 10-, 20-, or 30-day readings. It can include the intraday data but most often is calculated from one day's closing price to the next. This data is also seen in such indicators as the Average True Range and Bollinger Bands. Some people try to use these as alternative "VIX" measures for individual equities, but the VIX is an Implied Volatility Index and does not measure historical volatility.

Implied volatility is the volatility expectation that is priced into individual options. The implied volatility of an option is actually backed out of the price of the option. All the inputs of an options pricing model are known (time to expiration, strike, price, interest rates) except for the volatility that the option is pricing in. So that value can be backed out and allows the traders to understand the relative value of the option's price. Is a $1 call cheap or expensive? Looking at the implied volatility allows you to get an idea of its relative value.

Volatility, of course, is a measure of uncertainty. A high-volatility stock has a greater potential range than a low-volatility stock. But when we talk about the above types of volatility, the measure is a statistical formula that determines the one standard deviation annual distribution.

Example: If we have a stock trading at $100 with an implied volatility of 25 percent, the options are implying that the stock will be higher or lower by 25 percent within one standard deviation. (One standard deviation equals 68 percent in a normal distribution.) So the stock has a 68 percent probability of being between $75 and $125.

Volatility example

While the volatility data that we usually look at is an annual figure, you can also get monthly or daily numbers. The daily data can be obtained by dividing the volatility figure by the square root of the number of trading days in a year, which is usually accepted as 252. So if the volatility is 32 percent, the daily moves should be 2 percent (32 divided by the square root of 252, or approximately 16). That means that 68 percent of the time the daily moves should be 2 percent or less.

Volatility Charting

Most traders worry less about standard deviations and more about measuring the implied volatility of an option against past implied volatility and/or the historical volatility. This is where volatility charts are very useful, because they show the historical volatility against the average implied volatility.

Theoretically, the implied volatility for all options of a given underlying should be the same, but that isn't the case. So implied volatility averages can be used for given months or given time frames. This allows one to get a single number for implied volatility that can be charted. Often the 30-day average implied volatility is used, as is the case with the CBOE Volatility Index (VIX). Below is a chart of the 30-day historical volatility and the average implied volatility for the S&P 500 Index (SPX).

Volatility charting example

Valuing Options

There are several ways to use volatility data to value options. The basic premise is the same with volatility as it is for stocks: Buy low and sell high. The first is to simply compare the implied volatility to the historical volatility.

The theory is that if the historical volatility is greater than the implied, then the option is cheap; if the historical is less than the implied, it is expensive. This can be done using the spot data of the day, but that often presents an incomplete picture. As can be seen from the above chart, under this theory options appear expensive in early January but get much more expensive. And they appear cheap in late February and early March but get much cheaper.

Volatility charts allow traders to do more thorough analysis. Comparing the implied volatility of an option to past implied volatility and historical volatility allows for higher probability trades.

Appropriate Strategies

Many option traders focus specifically on volatility. Much research has been under the thesis that changes in volatility are much easier to predict than changes in the underlying asset prices. Volatility is, after all, mean-reverting and bounded both to the upside and downside. But even directional traders who only want to use calls and puts for leverage or protection can benefit greatly from a basic knowledge of volatility.

When the implied volatility is low, it is a generally a good time to buy an option. When implied volatility is high, it can be a good time to sell an option or use a spread strategy. Those who stick with directional trades are best served by using call or put spreads when implied volatilities are high. Those using covered calls are best served selling calls when they are relatively "overpriced."

Example: Buying a call versus a call spread when implied volatility is low in Cisco:

Volatility strategies example Volatility strategies example Volatility strategies example

Example: Buying a put versus a put spread on high implied volatility in Cisco:

Volatility strategies example Volatility strategies example Volatility strategies example

It is important to know how implied volatility can react to upcoming events. The implied volatility often gets inflated leading up to news releases or earnings announcements. After the news is out--when the unknown becomes known--implied volatility tends to drop sharply. This is the reason that many traders who have bought an option before such an announcement, and been right on the direction, still lose money. The following chart from LiveVol.com shows how implied volatility (the red line) gets inflated and deflated around earnings announcements (the blue line is the 30-day historical volatility).

Volatility implied/historical example

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