Volatility is the rate of change of a specific financial asset like stock, currency, index, or commodity. For example, a company whose share price is range bound or consolidating is said to have low volatility. On the other hand, a firm whose shares move up and down is said to be highly volatile.

Example: A stock that trades between Rs 200 and Rs 300 would be considered more volatile than another that trades between Rs 250 and Rs 300. For a meaningful comparison, price movement should be measured over the same period, i.e., over a week or two months.

When trading in financial instruments at an exchange, there are two types of price volatility that traders and investors need to understand.

#### Types of Volatility

- Historical Volatility, and
- Implied Volatility.

### Historical Volatility

As the name implies, historical volatility measures how volatile a stock has been in the past.

The easiest way to measure historical volatility is first to measure the standard deviation over a set period for the stock you are looking at. Then divide the stock price by the standard deviation to get the historical volatility expressed as a percentage. Standard deviation is a statistical calculation that indicates the extent of deviation within a group or a data set.

**Mathematically, historical volatility is the (usually annualized) standard deviation of returns**.

Standard deviation gives one-day historical volatility. Next, we find annual volatility as below:

#### Annualizing the Volatility

Convert 1-day volatility to 1-year volatility because that is how it is typically quoted. We do that by multiplying 1-day volatility by the square root of the number of trading days in a year. For example, if there are 252 trading days, then the square root of 252 would be 16.

The result is annualized historical volatility.

A volatile market has a high standard deviation and, thus, a high historical volatility value. Conversely, a market with small fluctuations has a minor standard deviation and a low historical volatility value.

Historical volatility can also be used as a tool by traders trading in cash and derivatives segments. . Quantifying the volatility in a market can affect a trader’s perception of how far the market can move and thus provides some help in making price projections and placing orders. For example, high volatility may indicate a trend reversal as heavy buying or selling comes into the market and may trigger price reversals.

#### How Historical Volatility Works?

- Historical volatility does not measure direction. Instead, it measures how much the securities price deviates from its average.
- When a security’s Historical Volatility is rising or higher than usual, it means prices may rise or fall more quickly than usual and indicates that something is expected to change, or has already changed, regarding the underlying security, i.e., there is high uncertainty in the security prices.
- When a security’s Historical Volatility falls, things return to normal, i.e., uncertainty has been removed.

### Implied Volatility

Implied volatility is a forward-looking measure of volatility. Rather than looking at a stock’s price movement in the past, implied volatility attempts to quantify how much it will move in the future. This becomes especially relevant when trying to gauge the price of Options. For example, implied volatility would be guessing how far the Options value may deviate.

One of the most critical factors in implied volatility is event risk. Event risk occurs when a macroeconomic or company-specific event in the future can positively or negatively impact a stock’s price. Options often have greater implied volatility when major stock events are on the horizon. For example, before a company’s earnings report, its options have increased implied volatility. After the report has been released and the stock trades the next day, some implied volatility is removed from the stock’s options.

- Low implied volatility tells us that the market isn’t expecting the stock or options price to move much from the current price over a year.
- High implied volatility tells us that the market expects large movements from the current stock or options price over the next year.
- The higher the implied volatility, the higher the price of the option.

Implied volatility is an annualized expected move in the underlying asset price, adjusted for the expiration duration.

It’s important to note that implied volatility is not an exam. Instead, it is science. It is a forward-looking calculation that allows investors to estimate where the market is headed.

Implied volatility is also often seen as a measure of supply and demand for options. Like securities prices, implied volatilities rise when there is more buying interest, fall when that interest fades, or sell interest. Because most traders do not intend to hold options to expiration, high or rising implied volatilities can indicate increased demand for those options, and low implied volatilities indicate reduced demand.

Options traders will compare historical volatility to implied volatility to help decide whether an option is overpriced, underpriced, or appropriately priced. If implied volatility seems too high, traders will employ strategies that look to sell volatility. If implied volatility is too low, they will look to buy volatility.

### Bottomline: Volatility Indicates Both Probable Price Movement and Traders’ Interest

Historical volatility measures how volatile a stock has been in the past. In contrast, Implied volatility is a forward-looking measure of volatility that attempts to quantify the future movement of a stock or options.

Traders compare historical and implied volatility to uncover short-term trading opportunities to exploit to make profits.

Generally, options traders look to buy options when implied volatility is low since premiums are lower, hoping to see the underlying stock move in a favorable direction along with an increase in volatility which will increase premiums. Whereas traders look to write options when implied volatility is high as option premiums tend to be higher, in hopes of seeing the underlying stock move in a favorable direction to their position along with a decrease in volatility which would make premiums decrease.