Understanding options volatility: Implied vs historical volatility
Options trading is arguably one of the most popular and profitable ways to trade stocks, bonds, commodities, and other assets. However, to understand how to capitalise on options trading opportunities, traders must first understand the concept of volatility. Volatility can be measured in two distinct ways: implied volatility (IV) and historical volatility (HV).
Implied volatility measures expected future volatility derived from an option’s prices. Simply put, IV reflects market expectations for how volatile an asset will be over the life of an option contract. It also measures the amount of risk associated with an underlying security. Implied volatility should not be confused with its actual realised or historical counterpart; instead, it is a projection of anticipated movement.
The calculation of IV is complex and involves using an option pricing model, such as Black-Scholes. This model considers the stock price, strike price, time to expiration, interest rates, and other factors to determine a predicted volatility number for any given option contract.
Since IV is derived from an option’s prices in the open market, it can be thought of as a barometer of overall market sentiment towards the underlying asset; when investors expect movement in either direction (up or down), they will demand higher premiums for the options associated with that security. The higher premium reflects this increased risk and willingness to pay more for those contracts due to their perceived value.
In contrast to implied volatility which looks forward, historical volatility is a measure of past price movement over a specific period. It considers the rate at which an asset has moved in the past and gives traders a better understanding of how much risk they might take in the present.
To calculate HV, traders typically use mathematical formulas such as standard deviation or variance to determine the average fluctuation of an asset’s price. The parameters used for these calculations are usually based on daily returns over a specified time frame; however, different time frames can also be used depending on the strategy employed.
HV can provide traders with insight into potential future movements; for example, if two assets have similarly implied volatilities, but one has had higher historical volatility, it is likely to provide more significant potential for profits. Additionally, HV can be used to compare different assets to determine the risk/reward ratio.
Understanding implied and historical volatility
When fx options trading, it is essential to have a good grasp of implied and historical volatility to make informed decisions. As noted earlier, IV reflects market expectations for how volatile an asset will be over the life of an option contract. In contrast, HV gives traders an insight into past price movements that may influence future ones.
By being able to accurately read both types of volatility, traders can take advantage of profitable opportunities when the two converge; when IV is higher than HV, there may be a chance to buy deep out-of-the-money options, as the market is expecting more price movement than what has been seen in the past. Conversely, when IV is lower than HV, there might be an opportunity to sell expensive deep-in-the-money options since market expectations are less than historically observed.
What are the risks?
Although understanding volatility can be beneficial in fx options trading, there are risks associated with IV and HV. When an option is overpriced due to the market expecting more price movement than historically, it is possible to stay that way until expiration. It means traders may end up paying more for the option than if they had correctly anticipated the market’s sentiment.
Additionally, when trading options with high historical volatility, it is essential to remember that past performance does not guarantee future returns; the underlying stock may continue its previous trend or quickly reverse direction without warning, which can result in losses if a trader enters a trade without proper risk management strategies.
Understanding volatility metrics such as implied and historical volatility can give traders an edge in their trading strategies. By considering both types of volatility and how they interact, traders can identify profitable opportunities that otherwise may have gone unnoticed. As always, it is essential to remember that no two markets are ever exactly alike, and every trade should be based on sound analysis of all available data. Doing so will help traders make informed decisions and capitalise on their investments.