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 in value, both up and down.
There are two forms of volatility, however. Historical volatility, which measures past price movements, and implied volatility, which estimates future price fluctuations based on options pricing. It’s crucial for participants in these markets to understand the difference between implied vs historical volatility.
Key Points
• Historical volatility measures the range of returns on a market index or security over a given time period.
• Traders use historical volatility to set stop-loss levels and analyze riskiness.
• Historical volatility is different from implied volatility, which is forward-looking.
• Implied volatility measures expected future volatility based on options prices, reflecting market expectations.
• Higher implied volatility tends to lead to higher options premiums since the price is more likely to jump to a trader’s advantage (or disadvantage).
Historical Volatility Definition
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 its price movements during a period of time.
Investors use historical volatility to get an idea of how likely the stock is to make large movements in price. A stock with higher volatility may indicate elevated risk, because there is a higher potential that the stock’s price could rise or drop significantly.
Highly volatile investments purchased with leveraged accounts can create additional risk. On the other hand, a stock with higher historical volatility could also be potentially more rewarding, since there is also a possibility that the stock’s price could make a big jump upward (or downward). Stocks may 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 easier to compare historical volatility between stocks — even if they have very different values — while assessing investment opportunities. When comparing the volatility of stocks, it’s important to look at them during the same time period.
Implied Volatility Definition
Implied volatility measures a stock’s expected future price fluctuations, derived from options prices, and is commonly used by traders to assess market uncertainty. 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 often assess implied volatility using metrics like Vega, one of the Greeks in options trading, which measures how sensitive an option’s price is to changes in implied volatility.
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.
Recommended: Understanding the Greeks in Options Trading
Historical vs Implied Volatility
Although both implied volatility and historical volatility measure the volatility of stocks, 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
Historical volatility is used for assessing a stock’s past price movements. It demonstrates a stock’s value fluctuation over a specific period, and may provide an idea of the risk associated with it. Investors use historical volatility to gauge the potential for future price swings based on historical data.
Implied volatility may help an investor evaluate options pricing or forecast potential future price movements. This figure reflects the market’s expectations for future volatility, based on the prices of options contracts. Traders often use implied volatility to determine whether options are overpriced or underpriced relative to expected price movements.
For example, a trader could look at options with implied volatility that differs from its 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:
Historical volatility is used to analyze a stock’s past price movements, regardless of whether the investor is purchasing the stock itself or trading its options. It can help assess the stock’s risk or potential for large price swings, which is valuable for both stock investors and options traders.
Implied Volatility:
Implied volatility is specific to options because it’s derived from options prices, reflecting the market’s expectations of future volatility. Implied volatility isn’t just for options traders, however. It can also be useful for stock traders as an indicator of market sentiment about the stock’s future price movements.
| Historical Volatility | Implied Volatility |
|---|---|
| Calculated using the historical prices of a stock or index | Determined indirectly based on the prices of options contracts |
| Used by investors as well as traders to analyze a stock’s movements | Used primarily for options and based on options prices, which are based on market expectations of volatility |
| 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 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 you can incorporate some of these ideas into your trading strategies is 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.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
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.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
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 calculated directly from historical data. Rather, it is derived from the market 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 INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest®
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOIN-Q324-065