Historical vs. Implied Volatility - YouTube

Hey everyone.

This is Kirk, here again at optionalpha.com.

And in this video, we're going to be talking about historical versus implied volatility.

This is something that really trips up a lot of traders as they start to get deeper and

deeper into options trading education.

So hopefully, this video will present it very simply (as always) and straight to the point.

Let's just do a little refresher on what volatility is again, just so everyone's clear.

Volatility is simply a measure of risk or uncertainty on the underlying stock.

It only suggests the magnitude to which a stock will move, not the direction.

This is a really key point.

We can have markets that rally and are high volatility markets.

Most people really equate volatility with falling markets, but that's not the case.

Volatility is in any direction, just as a magnitude measurement.

So again, with our stock price example here, we'll take two stocks that start trading in

the beginning of the year at $100.

The first stock has low volatility here on black and is trading just generally around

the market range.

And again, it's trading just generally around this $100 range.

The other stock in blue has much, much more violent swings.

It has bigger swings.

They're more radic, more spaced out.

That's more of a high volatility stock.

Well, technically speaking, historical volatility is annualized standard deviation of past stock

movements, right?

So, what the heck does that mean in English?

Well, it really means how much the stock price has fluctuated on a day-to-day basis over

a one-year period.

So, let's just (for example) take stock A's 52 week range.

It's 45 to 55, right?

Pretty tight and narrow range, even though it's a high-priced stock.

Well, stock B is a little bit more volatile and that its 52 week range is 5 to 55.

Much, much more volatility over the last year.

So, historical volatility timeframes are calculated using a one-year timeframe.

And it's important to understand that historical volatility is measured in actual trading days,

not just days.

This is a real key point because most months (even though they're 30 or 31 days) are going

to have weekends.

And since the market doesn't trade over the weekends, we're going to have each 30 days

be approximately 21 real trading days.

So, when we talk about a one-year timeframe, it's going to talk about actual trading days.

With volatility, you can either have short or long-term trends.

And so, when you set your indicators to take a look at historical volatility, you can have

short-term indicators that look at historical volatility over the last 20 trading days,

21, 50, 60, or even 90.

Those are all really considered short-term volatility indicators.

When we talk about historical volatility over the long-term, now we're going to be into

the 100, 180, 200, and 250 type of range.

So again, those are the real differences between historical volatility for short-term and for

long-term.

Now, let's get into implied volatility.

Implied volatility isn't based on any historical pricing data on the stock.

It's actually based on what's the sound of its name.

And that is that implied volatility is implying the volatility of the stock in the future,

based on price changes in the underlying options.

So as option traders, we want to focus on implied volatility rather than historical.

Historical is (as it suggests) history.

It is in, it's already done, it's already happened, it's the past.

And implied volatility is forward-looking indicator, so we want to focus more on how

implied volatility looks as compared to historical volatility.

There are some basic trading assumptions that you're going to make throughout the month

when you're looking at implied volatility.

So throughout the month, option traders are going to start to form opinions and assumptions

about where the stock is going to go in the future, right?

We all have an opinion, we all speculate, and that's why we're in this business.

So big earnings, court rulings, etc. are going to cause people to buy or sell options at

various levels.

If they're really bullish, they'll be really out of the money.

If they're a little bearish, they'll be really out of the money on the bearish side.

But all of this is going to change the price of those options without the stock price ever

changing itself.

It's just where people are placing their bets, and that's really all it means.

So, these changes in option pricing give us implied volatility, gives us the expected

range of the stock going forward.

Really, it shows us where other traders are placing their bets and where the market that

masses think that the stock is going to go.

So, when we talk about implied volatility and stock ranges, we're going to use this

example that I have up here.

An implied volatility statistics are expressed as a percentage of the stock move.

So for example, let's say we have a stock that's trading currently at $50 and we have

implied volatility of about 20%.

So, 20% of $50 is going to equal a 10% move.

Now, remember that I said it's only a single standard deviation.

So basically, what that means is that that 20% is going to capture 68% of the probability

movement in the underlying stock.

So again, just calm down and listen to me say this again.

But implied volatility rating of 20% is going to capture 68% of the movement overall of

the stock for the year.

So 68% of the time over the next year, the stock is likely to move between $40 and $60.

So again, $10 in either direction or 20% move in either direction, 68% of the time, that's

where the market is going to move.

Now, what about this extra 16% on either end which is more than a single standard deviation

away?

Now, that 16% is the outside range.

So 32% of the time next year, the market is not accounting for the fact that the stock

could actually move beyond this $10 in either direction.

And that's something that you really have to consider.

This 20% here doesn't necessarily mean that's the most it can move over the given year.

That is the one standard deviation move from where the stock price is.

Now, the most important thing (and this is why I've bolded this in red) is that implied

volatility is simply market theory.

We really have to drive that point home here.

Just because people are placing bets for 20% of volatility move does not necessarily mean

that's what's going to happen.

That's where bets are being placed.

It's not the actual movements of the security.

So, everything is just market theory.

You want to focus on stocks and indexes that have more option traders, more people trading.

That's going to give you a better reading of the market masses.

And you want to shy away from implied volatility levels that are extremely high with absolutely

no option volume.

And that really just means that there's nobody there, and therefore, implied volatility levels

are not realistic.

So, some key points to remember about historical versus implied volatility.

To be successful with options, you have to be great with both direction and timing of

the move.

And that's just the true essence of trading in general.

We really have to be good at taking advantage of direction and timing with options trading.

Now, historical and implied volatility can help take the guesswork out of potential stock

ranges because this gives you a point of reference going forward.

So, if historical volatility is low, but implied volatility is high, then possibly, the market

is expecting a huge move soon, but it could calm down later on and vice versa.

So, implied volatility is determined based on market participant actions like we talked

about before.

So, avoid options with low volume and open interest, as these are not true representations

of the herd or of the market masses.

If there's nobody trading the options, then the implied volatilities levels might look

high and it might look like the stock may have a big breakout.

But in reality, there's nothing that the market can price it off, so it just prices very minimal

volume low volume stocks and options.

So hopefully, this has been really helpful for you guys.

As always, thanks for watching, and take a second to share this video with any of your

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