What Options Traders Need to Know About Volatility

Today we are taking a closer look at volatility -- specifically, what it means when there is an abundance or lack of volatility, as well as the two primary types of volatility each options trader must know. In the simplest terms, volatility is defined as the propensity of the underlying stock's market price to change in either direction... but there's much more to the topic than that. Below, we will specifically dive into the differences between historical and implied volatility.

Historical Volatility vs. Implied Volatility

Historical volatility (HV) is a backward-looking metric that measures how much movement a stock has experienced over a certain time frame. HV is typically based on a stock's changes from close-to-close, whereas intraday swings are not priced in.

While there are several different methods by which HV can be calculated, it's most common to take the standard deviation of the difference between the stock's daily price changes, and compare it to the mean value of the stock during that same lookback period.

Implied volatility (IV) is a forward-looking metric that measures the market's best guess of future volatility over a certain time frame. This "implied" movement is a major factor that influences the price of an option. IV tends to rise ahead of scheduled events that could spark major stock moves, and then deflate after the catalyst has passed, in what is known as a "volatility crush."

What Does Volatility Mean for Options Traders?

Diving deeper and looking into the roles HV and IV play for options trading decisions, traders often compare a stock's HV to an option's IV, to determine whether or not options are pricing in a "fair" amount of future volatility over a given time frame. The time frames of HV and IV should be similar when comparing -- e.g., a 30-day HV to a 30-day option.

Option buyers should be wary when IV appears to be running much higher than HV, as that could mean options are overpricing volatility expectations. When the implied volatility is notably lower than the historical volatility, it may indicate an opportunity for option buyers to find relative bargains.

How We Measure Volatility

There are two tools our traders use internally that help us to analyze options prices and pinpoint the best option-buying (or option-selling) opportunities. The first tool is the Schaeffer's Volatility Scorecard (SVS). The SVS is a proprietary indicator that measures a stock's realized volatility versus the volatility expectations that were priced into that stock's options over the past 12 months. The goal of this backward-looking measure is to figure out which stocks have been the best and worst targets for option premium buyers. 

The second tool we use is the Schaeffer's Volatility Index (SVI), which is forward-looking. The SVI reflects the average at-the-money (ATM) implied volatility of a stock's front-month options, and we further quantify this reading by assigning it an annual percentile rank. This method is helpful to determine whether or not short-term options are currently pricing in high or low volatility expectations, relative to the past 52 weeks' worth of data.