I’m sure you’ve noticed I spend a lot of time talking about volatility …
Specifically, the CBOE Volatility Index (Ticker: VIX).
The VIX measures the implied volatility of S&P 500 options.
And as options traders, we tend to focus a lot on implied volatility, because it has such a profound effect on options pricing.
But … there’s another part of the equation we ignore far too often.
And it can be key to locking in your trading edge.
Here’s the two types of volatility you need to be watching.
The Price (Change) Is Right
First things first: what the heck is volatility?
Simply put, volatility measures the size of price changes in a security over time.
If a stock price tends to swing wildly, it has higher volatility.
If it tends to move only in small ticks, it has lower volatility.
Now, there are two types of volatility we’re looking at today …
Implied volatility (IV), which looks at future volatility, and historical volatility, which looks at actual stock movement from the past.
Historical volatility (HV) is also referred to as ‘realized volatility.’ Technically, realized volatility (RV) is only current volatility, or short-term historical volatility, but colloquially, you’ll likely hear them used interchangeably.
You can look at different durations of historical volatility – for example, 10-day, 20-day, 30-day, 90-day, and so on. Looking at longer-term HV will ‘smooth’ out sudden spikes and drops to give you a better idea of how the equity behaves over time. Meanwhile, if you’re more concerned with what the equity is doing lately, the 10-day or 20-day HV might actually be more useful.
Here’s the 10-day (white), 20-day (light blue), 30-day (gray), and 90-day (dark blue) historical volatility for GameStop (Ticker: GME). Notice how the longer duration of HV smooths out the many volatility pops found in the 10-day HV.
As far as implied volatility, it is more common to look at the 30-day duration than any other duration – but of course, in theory, you can look at whatever duration you want!
Now, here’s the big difference between HV and IV …
We KNOW historical volatility because it already happened, so we can measure it. We don’t have to guess or estimate – we have the data.
Implied volatility, however, is our best guess at what will happen in the future. Specifically, when looking at the implied volatility of an option, the IV is what the market expects to happen between right now, and when the option expires.
When you are looking to trade, looking at both historical and implied volatility is one way to give yourself edge in your trading – that is, it is one way to make sure that an advantage is inherently built into the trade you are making.
You want to take a holistic view of the volatility within the trade you are considering.
Look at the different durations of historical volatility to get an idea of which direction volatility is currently trending. It is important to look at longer-term and shorter-term HV to tell if a sudden pop or drop in HV is a short-term change, or if it looks like it may be the start of a longer-term volatility swell.
One critical thing to know that both historical and implied volatility are mean-reverting.
Every equity has an average volatility ‘zone’ that its volatility will tend to hang around in most often.
If you look at the current HV and IV of an equity and notice that either is out of whack (too high or too low), you can assume that eventually, it will return to ‘normal’ levels.
Of course, the timeframe for this is not guaranteed (that’s the tricky part!).
I would also recommend looking at the current volatility not only in the stock you want to trade, but in the market overall, to see if there is perhaps a driving force for the current volatility conditions you’re looking at in a particular equity. (For example, if the VIX is hitting 60, like we saw during COVID, we would expect to see elevated vol in pretty much everything!)
What Are You Implying?
Next, we need to take a look at the implied volatility within an equity’s options.
Take a look at this chart of Amazon’s (Ticker: AMZN) 30-day implied volatility.
Notice that while volatility may spike higher, and drop lower, there seems to be an average ‘zone’ that AMZN vol likes to hang around in.
So when IV is significantly higher or lower than that ‘normal’ zone, you can expect it will revert back.
And you can take advantage of this in your trading.
For example, if you notice IV has spiked, you can assume right now may not be the best time to buy options, as they will be more expensive – but it might be a great time to sell them, and collect more premium!
Or when IV is unusually low, you can assume it will eventually revert to its higher mean … making it a poor time to sell options, but a good time to buy.
Another tip is … you want to compare the current IV and recent HV to determine if traders are under-pricing volatility expectations.
For example, Globalstar (Ticker: GSAT) traders are currently pricing in lower volatility expectations than what the stock has actually been seeing.
The white line indicates GSAT’s 10-day HV, the blue line is the 20-day HV, and the red line is the 30-day IV.
This shows me that GSAT has been making larger moves than what traders have been pricing into options lately — so now might be a good time to make a move on GSAT.
There are often trades with favorable volatility pricing, and trading edge, available if you know where to look.
By finding an option with a lower IV, you are (hopefully) able to take advantage of the greater movement indicated by HV without paying extra premium to do so!
This is a great way to find trading edge.
And as for looking at the specific options to buy …
These will help you identify specific terms and contracts that are pricing in lower volatility – and are therefore more of a “bargain” for buyers.
Knowing and using all of the dimensions of volatility will help you trade smarter — and hopefully more profitably.
Your Only Option,