Implied Volatility vs Historical Volatility: What Options Traders Need to Know

Learn the difference between implied volatility vs historical volatility and how options traders can use IV and HV to evaluate premiums and risk.

Why Volatility Matters in Options Trading When you are involved in options trading, volatility is one of the figures you must not ignore. While the current price of the underlying stock shows you where the stock is, volatility provides another element of the picture by indicating how much the market has moved or how much movement is built into the options. This is important since the premium of an option is affected by a number of factors, such as the price of the underlying asset, the strike price, the expiration date, interest rates, and volatility. According to Cboe, volatility is a statistical measure of the dispersion of returns over a certain period, and thus it provides a means of measuring both the speed and the size of price changes. In the analysis of options, two measures — Implied Volatility (IV) and Historical Volatility (HV) — are commonly encountered. Although they may appear similar since both are given as percentages, they in fact address different questions. Historical volatility looks back at actual price movements, whereas implied volatility is obtained from current option prices and represents the volatility that is being priced into the market for the future. The Cboe also makes the same distinction, separating forward-looking implied volatility from realised or historical volatility based on known prices. Therefore, by understanding the difference between implied volatility and historical volatility, traders will be able to put option premiums into context. It won't tell you whether or not a trade will be profitable, and it won't predict the exact direction that the stock will take; rather, it provides you with another way of looking at the risk, pricing, and expectations associated with an options position. What Is Implied Volatility? Implied volatility is the level of volatility that is implied by an option's present market price. To put it simply, the market price of an option reflects the degree of price movement that traders are incorporating into the contract. A pricing model can calculate the volatility figure which makes the model's theoretical price equal to the actual market price by using the option price and other known inputs. It is therefore unlike merely assessing how much a stock has moved in the past; it is sometimes referred to as forward-looking since the option price takes into account the market's expectations of future uncertainty. Yet the IV should not be regarded as a sure prediction. A stock having an IV of 40% is not certain to show 40% annualized volatility, and the IV also does not indicate whether the next big move will be up or down. For example, suppose there is a stock trading at $100. If traders are ready to pay relatively high premiums for its options since they expect larger price fluctuations around a forthcoming event, then implied volatility will go up. The stock price might stay near $100 while implied volatility rises since the options market is adjusting for the possibility of future