Volatility – is a formula that demonstrates fluctuation of underlying assets value and is usually expressed in a coefficient percentage. In simple words, it is a risk or uncertainty about the size of changes in a security’s value. Whereas many people consider, that volatility is a certain trend that moves in different directions in a stock price. And this definition is not exactly correct.
Every trader has to be aware of two volatility forms: implied and historical. The word “implied” in “implied volatility” phrase speaks for itself. It means that the market defines and implies volatility of the stock which will be in the nearest future considering all the changes in an option.
The reason for changes in an option is usually caused by changes in option prices. For example, when traders change some trading patterns it will automatically affect options, meaning that their price will either increase or decrease.
As a rule when implied volatility goes up the option prices increase too and on the contrary. Consequently the rise of an option for a trader is a huge advantage, yet bad news for an option seller.
It is very significant to understand the strategies you are going to use taking into account options you wish to buy or sell, expiration times etc. And one more rule: always remember that implied volatility is not and will never be a predictor of the stock market, because it is just a consensus in the marketplace.
There are many difficult and complicated definitions of historical volatility, though to really understand it, here is a simple one – it is the fluctuation percentage of stock price during a year on an every-day basis. The cost varies greatly throughout the year and at the end might have the same price as it was in the very beginning. But there are times when it can greatly increase or decrease, for instance, in the beginning of the year the stock was $100 and in a year it can be either $175 or $25.
Being a good trader isn’t that easy as it might seem from the first glance. It is important to not only guess the direction of the stock but also know the timing of this particular move. And exactly for this purpose, implied and historical volatility understanding is needed. They will simply make the guess easier and faster.
Remember that implied volatility is based on the marketplace and what it expects the stock to do in theory. In many cases theory isn’t the same as real world. Understanding this, we can conclude that implied volatility is not and won’t be 100% accurate, therefore it is always significant to have the latest information the financial market is capable of giving us.