Thursday, August 16, 2007
WHAT IS VOLATILITY?
Volatility is a measure of risk / uncertainty of the underlying stock price of an option. It reflects the tendency of the underlying stock price of an option to fluctuate either up or down. Volatility can only suggest the magnitude to the fluctuation, not the direction of the movement of the price.
In options, there are 2 types of volatility:
1) Historical Volatility (HV), or sometimes called Statistical Volatility (SV): A measure of the fluctuations of the stock price over the past 30 trading days.
Therefore, when there is a sharp move in the stock price (up or down) during that period, the Historical Volatility (HV) number will increase drastically.
HV is obtained by calculating the standard deviation of historical daily price changes (i.e. daily returns) over the specified period.
2) Implied Volatility (IV): An estimate of the volatility of the stock price for the next 30 trading days.
Higher Implied Volatility (IV) reflects a greater expected fluctuation (in either direction) of the underlying stock price. This could be due to earnings announcement is nearing, pending for FDA approvals, or some other important event / news, which is expected to move the stock price drastically.
IV can be obtained by finding the volatility figure that makes the theoretical value of an option to be equal to the market price of the option (calculated through Option Calculator / Pricer).
(Perhaps that’s why it’s called “Implied Volatility”, because it is the volatility "implied" by the option’s market price).
Both HV and IV are usually expressed as a percentage and annualized. Due to this standardized expression, the figures can be used to compare the volatility across different stocks, regardless of the stock price.
To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).
* FREE Trading Videos From Trading Experts You Should Not Miss
* Options Trading Basic – Part 2
* Option Greeks