Volatility is like a sunset. You’ve seen one, you’ve seen ’em all, right? Well, yes and no. Sure, volatility (“vol”) means how much the price of a stock or index might change. High vol suggests the market anticipates bigger potential future price changes. Low vol means the market anticipates smaller future price changes. Simple enough. But there are in fact two main volatilities you’ll typically encounter—historical and implied. And although they both refer to a price change’s potential magnitude, they’re calculated and employed differently. Whether historical or implied, vol is always a percentage, and usually an annualized number. If vol is 20%, for example, a stock or index might be 20% higher or 20% lower in a year’s time. Further, vol is a standard deviation of price changes. So theoretically, in one year, the stock will be within +20% and -20% of its prevailing price approximately 68% of the time. The stock will theoretically be within +40% and -40% approximately 95% of the time, and within +60% and -60% approximately 99% of the time. Statistically, vol is one standard deviation. But that’s about as much as historical and implied vols have in common.
It's History. Or Is It?
Historical vol is based on price changes for a stock or index over a period of time. That time can be a year, 10 days, or any time period. It doesn’t change for a given set of data, because a stock’s past price changes are what they are.
To calculate historical vol, you’ll have to do some mathematical calculations, but don’t sweat the heavy stuff. Historical vol is available on the thinkorswim® platform by TD Ameritrade as a study on the Charts tab. Select Studies > Add Study > All Studies and find Historical Volatility.
Implied vol or IV is a tad more complicated to calculate. It still uses the stock price in its calculation. Unlike historical vol, though, IV is always changing because option prices shift constantly, depending on how the market anticipates future price moves.
If you think a stock might make bigger price changes, option prices increase, which in turn increases implied vols. Conversely, if you don’t anticipate big changes, option prices decrease, which decreases implied vols.
Analyze historical vol to see how volatile a stock or index has been in the past, and implied vol to see how volatile the market anticipates a stock or index might be in the future. Compare the two to determine if one is higher than the other. For example, if you believe historical and implied vols should follow each other up and down, but you notice that implied vol is higher than historical, that could suggest implied vol overstates a stock’s potential price change. If implied vol is lower than its historical counterpart, that could suggest implied vol is understating potential price changes.
Getting your mind around vol isn’t a trading strategy per se, and you shouldn’t base decisions solely on the movement and relationship of historical and implied vols. But comparing them may help you peer into how the market feels.
For a fuller picture of historical and implied vols, add them on Charts (see Figure 1). By default, the two studies appear on separate panels. But if you go to the Edit studies section and click on the up-facing arrow on the lower study, it’ll move it to the same panel as the upper study. This overlays historical and implied vol data. With a little practice, you can mine vol territory fairly quickly for potential insights. Again, use implied vol to see what the market might be thinking, but turn to historical vol to see if the market may have veered off track. Think of it as checking the weather before you leave the house. You can’t control a downpour. But you can grab an umbrella and be a little more prepared.