by Amanda Harvey
Implied volatility is one of the two major gauges of stock market volatility, with the other being historical volatility. Volatility is the term used to describe the amount and rate of fluctuation experienced by the price of a security. Historical volatility is the measure of actual documented price variation over a period of time which has already passed. As such, this measure of volatility can give a factual representation of the amount of movement which has been experienced by the security price, as it is a backward-looking assessment.
Implied volatility (IV) on the other hand, is a method of predicting the probable future volatility that may be experienced by a security price. While this type of volatility calculation is obviously not an exact science, it is of great interest to traders as it gives the best possible indication of how much price fluctuation a security is likely to undergo.
The Importance of Implied Volatility in Trading
Especially for traders seeking to make short-term gains on positions, the level of IV is a major determining factor in deciding whether a security is likely to undergo sufficient price movement within the trader’s time-frame to make it a potentially profitable trade.
Options in particular are inextricably linked with IV and the level of volatility is actually one of the components in the calculation of their price. In general, the higher the volatility, the higher the option premium is priced. This is attributed to the concept that greater volatility offers a better probability of the option becoming profitable within the duration of its contract. An option with a low implied volatility is generally priced more cheaply, as there is less likelihood of it reaching its target price within the timeframe of the contract.
This options pricing relationship with IV is an important point for traders to be aware of. Beginning traders in particular may see low-priced options as a bargain, failing to understand that they are priced cheaply because they are likely to expire worthless, having failed to reach their strike price.
Comparing IV with historical volatility (HV) can help to identify whether options are fairly priced, or either over- or under-priced. When the IV is low in comparison to the HV, this may signify that the options are undervalued, whereas high IV in relationship to HV can indicate a situation of options being overvalued.
Indexes and Indicators
Implied volatility can be measured for specific stocks or options, and it is also gauged in broader terms by volatility indexes. Arguably the best known is the VIX, otherwise referred to as the ‘Fear Gauge,’ which gives a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
There are many indicators available which help a trader to assess both the level of implied volatility and in some cases, the probable direction in which that volatility will take the price of a particular security. One simple and effective volatility indicator is the Harvey’s Options Volatility Indicator.
This indicator applies data to a chart and the result is a volatility level reading with a positive or negative value. A zero level of volatility obviously indicates a stagnant price, whereas a figure of 5 or more in either direction suggests a more desirable amount of price movement. A negative 8 reading can be interpreted as a strong signal to buy a put option, whereas a positive 8 would mean that a call option is a good choice.
Some popular volatility indicators include the Parabolic SAR, the Chaikin Volatility Indicator, and the Average True Range.
Understanding the importance of volatility in trading, and determining effective ways of assessing the probable speed, amount, and direction of price movement is vital to developing effective trading strategies.