Today we are going to delve into the wonderful world of volatility.
Let’s start by defining exactly what I mean by volatility. Basically, volatility is the amount an underlying stock or ETF fluctuates over a specific time frame.
As traders, we only need to concern ourselves with two forms of volatility: historical volatility and implied volatility.
In today’s post I’m going to discuss historical volatility. I’ll save implied volatility for tomorrow. I want to discuss both terms and their importance in two small, digestible chunks.
Historical volatility is simply how much the price of a stock or ETF vacillated from day to day over the course of one year. If you want to get technical, the textbook definition is “the annualized standard deviation of price movements.”
Or you might find historical volatility easier to comprehend by thinking about it visually.
Below is a chart of the historical volatility of two different underlying stocks. Both start and end the year at $100. But look at the journey each one took over the course of the year.
Obviously the stock represented by the blue line was far more volatile than the stock represented by the black line. Taking a close look at historical volatility is important when trading options, particularly when selling options. But, it’s only when compared to implied volatility that historical volatility becomes useful. In a follow-up post I will introduce implied volatility and all of the characteristics that surround, in my opinion, the most important factor when trading options.
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