Whether you are a new investor or a seasoned trader, it’s common to hear the word “volatility” when discussing the movements of a stock price or index. More volatile stocks tend to have larger swings, both up and down.
However, depending on the context, the speaker may be referring to historical volatility, as in the case of comparing two stocks, or implied volatility, as in the case of discussing options prices. It’s crucial for participants in these markets to understand the difference.
Here’s what you need to know about implied volatility vs. historical volatility.
Historical Volatility Definition
Historical volatility is a statistical measurement of how much a given stock moves up and down. As the name suggests, historical volatility measures a stock’s price as compared to its average or mean. The most popular way to calculate a stock’s historical volatility is by calculating the standard deviation of a stock’s price movements over a period of time.
Investors use historical volatility to get an idea of how likely the stock is to make large movements in its price. A stock with higher volatility is inherently riskier, because there is a bigger chance the stock’s price will drop significantly. Highly volatile investments purchased with leveraged accounts can be even riskier still.
On the other hand, it can also be potentially more rewarding, since there is also a possibility that the stock’s price will make a big jump upward. Stocks tend to generally become more volatile during times of recession or uncertainty.
Investors measure a stock’s historical volatility as a percentage of the stock’s price and not as an absolute number. That makes it easy to compare historical volatility between stocks, even if they have very different values, when assessing investment opportunities. When comparing the volatility of stocks, it’s important to make sure you’re looking at them over the same time period.
Implied Volatility Definition
Implied volatility is another measure of the volatility of a stock. While historical volatility is backward-looking, implied volatility attempts to quantify a stock’s volatility going forward. Implied volatility reflects the prices of the options contracts associated with a particular stock. Options traders usually reference implied volatility with the Greek letter σ (Sigma).
A stock with a higher implied volatility generally has options contracts with higher premiums. This is because there is more uncertainty around the direction of the underlying stock.
Historical vs Implied Volatility
While both implied volatility and historical volatility measure the volatility of a particular stock, they measure it in different ways. Historical volatility reflects the past price movements of a particular stock or index, while implied volatility gauges future expectations of price movements based on the prices of options contracts.Traders use implied volatility when they are determining the extrinsic value of an option.
When to Use Historical vs Implied Volatility
One way to use implied volatility is to look for options whose implied volatility is different from the historical volatility. If an option’s implied volatility is lower than the historical volatility of the underlying stock, that may be a signal of an undervalued option premium.
Comparing Implied and Historical Volatility
Here is a quick summary of the differences between historical and implied volatility:
| Historical Volatility | Implied Volatility |
|---|---|
| Calculated using the historical prices of a stock or index | Determined indirectly based on the prices of options contracts |
| Used primarily for stocks or indexes | Used primarily for options |
| Measures past performance based on historical data | Projects future performance, representing an indicator of future volatility |
How to Use Implied and Historical Volatility Together
Because implied volatility and historical volatility measure different things it can be useful to employ them both. The historical volatility of a given stock or index will measure how much the price has historically moved, both up and down. If you’re interested in investing in options for a stock, you can look at how its historical volatility compares to the implied volatility denoted by the prices of its options contracts.
One way that you can incorporate some of these ideas into your trading strategies through a volatility skew. A volatility skew depends on the difference in implied volatility between options contracts that are in the money, at the money and out of the money.
Another relevant concept when it comes to implied volatility is a volatility smile, a graphic representation of the strike prices and the implied volatility of options with the same underlying asset and expiration date.
The Takeaway
Options traders often look at both historical and implied volatility when determining their options trading strategy. You may also use these tools while investing, or you might look at other factors to evaluate potential investments.
If you’re ready to start trading options, one way to start is with SoFi’s options trading platform. This platform offers an intuitive and approachable design where you can make trades from the mobile app or web platform. Plus, you can reference a library of educational content about options if questions come up along your investing journey.
FAQ
How is implied volatility calculated from historical volatility?
The historical volatility of a stock or index reflects the changes in historical stock prices. It is often, but not always, calculated as the standard deviation of a stock’s price movements. Implied volatility is not something directly calculated — instead, it is implied based on the prices of options contracts for the underlying stock.
Is there a difference between implied and realized volatility?
Realized volatility is another name for the historical volatility of a stock. So while implied and realized volatility both measure how volatile a stock is, they have different definitions, and investors use them in different ways.
Photo credit: iStock/kupicoo
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