One of the most important measurement and assumptions used in the trading of options is the volatility of a financial market. Volatility is a measurement of how much a market moves over a period. Most measures of volatility are based on an annualized measure of daily movements of the market. These concepts measure a period of daily movements and multiply this number by the square root of time to annualize the number. When referring to volatility, market participants reference two different types of market movements. The first is implied volatility, and the second is historical volatility.
Implied volatility is a term used to describe how much a market will move over a period in the future, on an annualized basis. Implied volatilities are measurement that are used to price options, and they are considered the markets view of how much a financial instrument will move in the future. Implied volatility is based on fear, greed, and supply and demand. Implied volatility is traded like a stock or a futures contract. It is a market-based measurement and therefore it fluctuates with market sentiment.
In the graph of volatility, the implied volatility of the QQQQ ETF has traded between 40% and 15% during the past 12 months. Traders will use this range to determine when implied volatility is relatively low and when it is rich or relatively high. At levels near 15%, trader will consider purchasing options, because the major input into pricing of options is low on a historical scale. When implied volatility is near 40%, traders will consider selling options, because prices of premiums will be relatively high. Traders can use technical analysis to determine the direction of implied volatility. One of the most effective strategies in determining the direction of implied volatility is using Bollinger Bands. Bollinger Bands measure a specific standard deviation around a specific moving average to determine how for a particular instrument can stretch. Since implied volatility is usually a mean reverting process, a instrument that measures mean reversion is a powerful tool in defining a range for this process. When traders use implied volatility to predict future implied volatility, they use a chart of historical implied volatility (or data of historical implied volatility).
The second type of volatility that market participants analyze is historical volatility. Historical volatility is calculated by taking the standard deviation of a time series and multiplying that number by the square root of time () which will return a decimal, which can be changed into a percentage). Since zero bounds most financial instruments, analysts will use a logarithmic return when calculating standard deviation and historical volatility. Historical volatility is a measure of how much a specific financial instrument has moved in the past. It is not a future looking measurement like implied volatility. Historical volatility is a measurement of the underlying financial instrument, where historical implied volatility is a measurement of implied volatility (where the market believes a financial instrument would move).
Most of the time, implied volatility will be above historical volatility. This means that market participants perception of how much a market will actually move, is greater that the reality. When looking at the graph of the QQQQ ETF implied and historical volatilities, one can observe that 95% of the time, over the past year, implied volatility is greater than historical volatility. A trader could infer from this logic, that the majority of the time, a purchased option will expire worthless. When a trader is looking to purchase options outright, it is important to gauge the relative value of the implied volatility. When implied volatility is relatively high (on the QQQQ ETF above 35%), a trader will avoid outright purchases, and will look for implied volatility levels close to 20% to make intelligent option purchases.
Volatility, both implied and historical is calculated on a closing price basis. For option pricing purposes, implied volatility is calculated on a daily closing price basis. The calculation is on an absolute value, which means that negative readings are viewed as differential. A market can be considered volatile, even if a financial instrument does not move very far. For example, if stock ABC moved up 10% one day and down 10% the next, continuously every day for a month after having daily moves of 2% for a period of 12 months, volatility would increase dramatically.
Investors need to monitor volatility to have a knowledgeable grip on the markets. When the markets are very volatile, investors should understand how that could affect their portfolio or new transactions. Outright purchases of options are skew against investors when implied volatility is high especially if the implied volatility is greater than a relative high of historical volatility. For example, when the QQQQ ETF implied volatility reached 35%, and investor would know that this is higher than any historical volatility point in the past year, and it would be unlikely that a market would move enough to reclaim the premium paid for a purchased option.
It is important to find a reliable source to attain implied and historical volatility charts, since these tools can make the different between successful options trades and trades that lose money.