How to Use Historic & Implied Volatility to Trade Options

by Linda Ray

Volatility is the movement of trading options, both up and down. When trying to gauge whether a stock will increase or decrease in value, two of the primary tools you can employ are historic and implied volatility. Historic volatility refers to the stock’s previous deviation over the past year. Implied volatility takes into consideration a stock’s history, but it also looks forward and takes into account how the market and the company’s activities will affect the future price.

Factors

A wide range of factors affects the implied volatility of a stock. First you have the implied expectations of the market, which include rumors and analysts’ forecasts. You need to take into consideration the current state of the economy, any mergers the company may have in the works, new product offerings and governmental regulatory changes. Other variables that factor into your predictions can include the current price of the stock, interest rates and dividends paid out by the company. After analyzing all the available data to come up with an implied volatility rate, then you use the historical data to hone your predictions.

Timing

Predicting the activity of a stock is both an art and a science. In addition to trying to figure out how much a stock will rise or fall, you also need to be fairly accurate about the timing of the changes to be a successful trader. Historical volatility can help you determine the timing once you’ve added in all the variables that affect the implied volatility of a trading option. For example, if a company stock historically spikes in the peak summer months, it’s a good bet the stock will again rise during the summer. If holidays usually surround dips in a certain stock, chances are holidays always affect that particular option.

Pricing

Use historical volatility numbers to determine if the current price of a stock is under or over-valued compared to its past costs. You’ll get even more accurate with your trading success when you gauge the span of time between spikes in the stock. For example, a historically high volatility ranking means that changes in the price occur more rapidly than stocks with historically low volatility deviations. The difference may affect the length of time you hold an option before the price drops again. Combined with expected volatile market changes, you can adjust your trading strategy to take full advantage of the stock to buy low and sell high.

Warning

Historical and implied volatility are tools and cannot be considered fool-proof methods for predicting whether an option will rise or fall before its expiration. Volatility merely tells you that the stock can move within a certain period of time based on its past performance and the variable market influences. It doesn’t tell you whether the move will be up or down. Relying on historical and implied volatility helps you get more accurate with your trading, but rarely does the real world comply with theoretical figures and calculations. Volatility predictions are especially useful for looking at stock performance over a longer period of time than you may have to meet option deadlines; it pays off to watch and study your stocks’ performance continually to fine tune your trading strategies.

About the Author

Linda Ray is an award-winning journalist with more than 20 years reporting experience. She's covered business for newspapers and magazines, including the "Greenville News," "Success Magazine" and "American City Business Journals." Ray holds a journalism degree and teaches writing, career development and an FDIC course called "Money Smart."

Photo Credits

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