Implied Volatility

As we discussed earlier, historical volatility is a useful measurement of the price movement of a stock over a given period of time. Historical volatility can be thought of as a sort of baseline standard for the price movement of a stock. The implied volatility, by contrast, is a kind of measurement of the expected price movement above or below that baseline standard.

Think of it this way: suppose you identify a stock with an average annual growth of 10% per year for the last five years. The stock has demonstrated a pattern of growth that forms the basis for an expected 10% annual return. Suppose that there is a very positive news announcement for the stock that may result in significant additional corporate revenues. Investors are likely to consider buying the stock, with the thought that the new opportunity may drive the stock price higher.

As you can imagine, investors aren’t the only ones expecting the stock to increase in value over the next few months. The market makers for both the stock and the options will typically raise the price of their securities with the expectation that the bullish news will encourage folks to buy the stock or options, even if they’re a bit overvalued. The market makers will seek to raise the price of their securities for as long as investors express a willingness to buy them. This increase in price is reflected in a higher implied volatility measurement.

By comparing the historical and implied volatility, we can see at a glance whether or not the market believes that the underlying stock is likely to increase in price, remain about the same, or drop in price.

Generally speaking, anytime the implied volatility is 20% or more above the historical volatility, the options are considered overvalued. Conversely, an option is usually considered undervalued if the implied volatility is 20% or more below the historical volatility. Many serious options traders will rely heavily on the implied volatility and even track it on a daily basis for a particular stock. If the implied volatility starts to increase, they may begin to look for bullish trades, believing the increased volatility may indicate a change in the market’s perception of the stock.