Ever wondered how the risk of an asset is measured with its price movement over time?
Probably, the most measures to perceive the market’s fluctuation is the historical volatility in options trading. What exactly is HV, how is it calculated, and how does this impact your trade? In the following article, we will show what Historical Volatility is, how it’s calculated, and how to incorporate it into an option trade.
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What is Historical Volatility (HV)?
Historical volatility (HV) refers to the measure of the degree of fluctuation in the price of a financial instrument, such as a stock or index, over a certain period. It is calculated as the standard deviation of the price movement within that period. In other words, HV is a measure showing the magnitude of deviation from the average price in the past and helps traders know about market behavior.
Understanding Historical Volatility (HV)
Historical Volatility (HV) is key in options trading. It measures how much the price of an asset changes. It looks at past price changes over a set time. When the asset’s price moves a lot, HV goes up. HV shows how unstable the market is. It doesn’t predict which way the price will move.
In options trading, HV is important. It affects the price of options. When HV is high, option prices (especially call options) tend to be higher. This is because the asset’s price might move a lot. This gives option holders a chance to make more money. When HV is low, option prices are lower.
HV helps options investors see how unstable the asset’s market is. It helps them guess how much the price might change. Then, they can pick the right options strategy.
For example, traders might use strategies like straddle or strangle when HV is high. These strategies make money when prices move a lot, no matter which way they go. If HV is low, strategies like covered calls might be better.
HV changes slowly over time. It doesn’t change much every day. People often compare HV to Implied Volatility (IV) to see if an option price is fair. IV is what the market thinks volatility will be in the future. It’s shown in the option price.
Besides pricing options, people also use HV in other technical analyses. For example, it’s used in Bollinger Bands. Bollinger Bands get wider or narrower around the average price when volatility changes. This change is measured by standard deviation.
Calculating History Volatility
1. Gather Historical Price Data:
The first step is to collect a series of past prices for the asset for which you want to calculate HV.
Choose an appropriate time frame: 30 days, 90 days, 1 year, or another period, depending on your analysis goals. More recent data usually reflects current volatility more accurately.
2. Calculate the Average Price: Calculate the average price of the asset over the chosen period.
3. Calculate Daily Price Changes: Find the difference between each day’s closing price and the previous day’s closing price.
4. Calculate Deviations: Find the difference between each daily price change and the average daily price change.
5. Square the Deviations: Multiply each deviation by itself (square it).
6. Calculate the Variance: Add up all the squared deviations. Divide this sum by the total number of prices in your dataset.
7. Find the Standard Deviation: Take the square root of the variance. This result is the standard deviation, representing the Historical Volatility (HV).
The Relationship Between Historical Volatility (HV) and Implied Volatility (IV)
Historical Volatility and Implied Volatility help investors assess the volatility of an asset and determine appropriate trading strategies. HV measures the actual volatility of an asset in the past; IV reflects the market’s expectation of future volatility.
The relationship between HV and IV plays a crucial role in option pricing.
IV ≈ HV: The option price is generally considered fair; trader other information, such as the market trend or events that would affect the pricing of the underlying asset, should be considered.
IV > HV: If the IV is too higher than the HV, the option price may be overvalued. This is good for the option sellers because they can demand a high premium. Traders can use various strategies like selling covered calls or credit spreads to benefit from the decrease in IV over time.
IV < HV: If IV is less than HV, then the option price may be undervalued. This is great for option buyers, and they can take long calls or long puts positions to create profits. They hope that IV will increase and thus increase the option. If it happens, the buyer can sell options at a higher price.
Example:
you own shares of Apple (AAPL). You notice that the current Implied Volatility (IV) is higher than the Historical Volatility (HV). You can selling a call option with a strike price ($190) higher than the current market price ($180) to receive a higher-than-normal premium.
If AAPL stays the same or goes up a little but doesn’t go over $190 before the option expires, you keep premium without having to sell your shares. If the price does go over $190, you still sell your shares at the price you wanted and keep the premium.
