by Amanda Harvey
Historic volatility (also referred to as historical volatility) is a measure of the amount and speed of fluctuation that has been experienced by a security price over a specific period of time which has already passed. Unlike implied volatility, which is a prediction of how much price fluctuation may be experienced by prices in the future, historical volatility or HV provides a concrete and accurate point of data.
HV is frequently expressed as an annual percentage which indicates the amount of variance that has been experienced by the price over the preceding 12 months.
How Is Historic Volatility Calculated?
The most popular method for calculating HV is by determining the average of the movement of prices from the average value of the asset. This calculation is also known as standard deviation, and it obtains its value as the square root of the amount of deviation from the average price.
Calculating a simple standard deviation starts by determining the average price for the number of periods involved. The next step is to calculate the deviation for each period, which is accomplished by subtracting the average price from the closing price. The deviations for each period should then be squared, and subsequently added together. The total of the deviations is then divided by the number of periods. The square root of the quotient of this division provides the standard deviation.
A higher standard deviation represents higher volatility as the prices have experienced a greater amount of fluctuation from their average. The reverse of course is also true, in that a lower standard deviation means lower HV.
What Is the Impact of Volatility on Traders?
While many options traders prefer to trade on options with a higher volatility, as there is a greater possibility of sufficient price movement occurring within the necessary time-frame, there are other considerations that all traders should be aware of in regard to volatility in trading.
There is the possibility with a time-sensitive trade, such as an option, that high volatility could result in a dramatic swing in the wrong direction at the time of expiration, leading to a loss.
One very important point that a trader should keep in mind is their own tolerance to risk and uncertainty, as with higher volatility comes the tendency for anxiety. If a trader is unable to withstand greater fluctuation in the price of their investment, they would be wise to choose securities with lower volatility. A reaction of panic to dramatic price swings may result in some individuals making untimely exits from a trade, thereby incurring losses.
What is the Relationship between Historic Volatility and Future Volatility?
While anything relating to future occurrences cannot be guaranteed, there is a strong suggestion that patterns are often continued. In other words, a stock which has been trading with a high volatility over a period of time frequently persists in doing so. A stock that has a pattern of low HV will often maintain this pattern, unless of course, there are significant internal or external factors which cause a strong increase in volatility.
It is also common for many assets to experience cycles of higher and lower volatility. Historical volatility charts can help a trader to analyze the cycles that have been experienced in the past, and to look for patterns and indications of the conditions that typically precede a shift in volatility.
Volatility is an important factor for traders in determining both the likely risk, and the possible return on an investment. Historical volatility provides an accurate measure of the amount of fluctuation that a price has experienced in the recent past, and may offer insight into the likely amount of future price movement.