The difference between a stock's historical volatility and the implied volatility from options pricing creates our edge as traders because we have proved that options pricing is expensive (rich) long-term.
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In this video, we’re going to be talking about historical versus implied volatility. This is something that trips up a lot of traders as they start to get deeper and deeper into options trading education. 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 in the underlying stock. It only suggests the magnitude to which a stock will move, not the direction. This is a key point.
We can have markets that rally and are high volatility markets. Most people equate volatility with falling markets, but that's not the case. Volatility is in any direction, just as a magnitude measurement.
With our stock price example here, we’ll take two stocks that start trading at the beginning of the year at $100. The first stock has low volatility here in black and is trading just generally around the market range, and 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 erratic, more spaced out. That's more of a high volatility stock. Historical volatility: Technically speaking, historical volatility is annualized standard deviation of past stock movements.
What the heck does that mean in English? Well, it means how much the stock price has fluctuated on a day-to-day basis over a one-year period. Let’s just for example take stock A’s 52-week range. It’s 45 to 55, pretty tight and narrow range even though it’s a high-priced stock.
Stock B is a little bit more volatile in that its 52 week range is 5 to 55, much, much more volatility over the last year. 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. 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 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 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. Those are the real differences between historical volatility for short-term and long-term.
Let’s get into implied volatility. Implied volatility isn't based on any historical pricing data on the stock. It’s 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.
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 a 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. Throughout the month, options traders are going to start to form opinions and assumptions about where the stock is going to go in the future.
We all have an opinion, we all speculate, and that's why we’re in this business. Significant earnings, court rulings, etcetera are going to cause people to buy or sell options at various levels. If they’re bullish, they’ll be really out of the money.
If they’re really 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 all it means.
These changes in option pricing give us implied volatility, provides us with the expected range of the stock going forward. It shows us where other traders are placing their bets and where the market that masses think that the stock is going to go.
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. For instance: Let's say we have a stock that’s trading currently at $50, and we have implied volatility of about 20%. 20% of $50 is going to equal a 10% move.
Remember that I said it's only a single standard deviation. What that means is that that 20% is going to capture 68% of the probability movement in the underlying stock. Just calm down and listen to me say this again. Implied volatility rating of 20% is going to capture 68% of the movement overall of the stock for the year.
68% of the time over the next year, the stock is likely to move between $40 and $60. $10 in either direction or 20% move in either direction 68% of the time, that's where the market is going to move. What about this extra 16% on either end which is more than a single standard deviation away? That 16% is the outside range.
32% of the time next year, the market is not accounting for the fact that the stock could move beyond this $10 in either direction and that's something that you 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. The most important thing (and this is why I've bolded this in red) is that implied volatility is simply a market theory. We 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. Everything is a just market theory. You want to focus on stocks and indexes that have more options 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 just means that there's nobody there and therefore, implied volatility levels are not realistic.
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 have to be good at taking advantage of direction and timing with options trading.
Historical and implied volatility can help take the guesswork out of potential stock ranges because this gives you a point of reference going forward. 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.
Implied volatility is determined based on market participant actions like we talked about before. Avoid options with low volume and open interest as these are not accurate representations of the herd or the market masses.
If there's nobody trading the options, then the implied volatilities levels might look high and it might seem like the stock may have a big breakout, but in reality, there's nothing that the market can price it off, so it just rates very minimal volume or low volume stocks and options.
Hopefully, this has been helpful for you guys. As always, thanks for watching. And take a second to share this video with any of your friends, family or colleagues on your favorite social network.