THURSDAY, SEPTEMBER 04, 2008

Historical Volatility (HV) vs. Implied Volatility (IV):

Definition

WHAT IS VOLATILITY?
Volatility is a measure of risk / uncertainty of the underlying stock price
of an option. It reflects the tendency of the underlying stock price of an
option to fluctuate either up or down. Volatility can only suggest the
magnitude to the fluctuation, not the direction of the movement of the
price.

In options, there are 2 types of volatility:

1) Historical Volatility (HV), or sometimes called Statistical

Volatility (SV): A measure of the fluctuations of the stock price over the
past 30 trading days.
Therefore, when there is a sharp move in the stock price (up or down)
during that period, the Historical Volatility (HV) number will increase
drastically.
HV is obtained by calculating the standard deviation of historical daily
prices over the period.

2) Implied Volatility (IV): An estimate of the volatility of the stock price

for the next 30 trading days.
Higher Implied Volatility (IV) reflects a greater expected fluctuation (in
either direction) of the underlying stock price. This could be due to
earnings announcement is nearing, pending for FDA approvals, or some
other important event / news, which is expected to move the stock price
drastically.
IV can be obtained by finding the volatility figure that makes the
theoretical value of an option to be equal to the market price of the option
(calculated through Option Calculator / Pricer).
(Perhaps that’s why it’s called “Implied Volatility”, because it is the
volatility "implied" by the option’s market price).

Both HV and IV are usually expressed as a percentage and annualized.

Due to this standardized expression, the figures can be used to compare the
volatility across different stocks, regardless of the stock price.

How To Get Historical Volatility (HV) vs. Implied Volatility

(IV) Information – Part 1

In the previous post, we discussed what volatility is and the differences

between Historical Volatility (HV) and Implied Volatility (IV). Now, we’ll
carry on with some websites for obtaining volatility information.

How To Get HV and IV Info

The following are the sources from which I usually find HV and IV info for
FREE:

1) ivolatility.com.
This site provides some tools & data such as:

• Stock’s Historical Volatility (HV) and Implied Volatility (IV) figures

(1 day lag).
• IV and Delta figures for near ATM options (No other Options Greeks
info).
• Options Calculator.
It can be found under “Analysis Service” >> “Basic Calculator” at the
left bar.
• Volatility Charts.
This chart shows Historical Volatility (HV) and Implied Volatility
(IV) for 3 months, 6 months, and 1 year window (The charts are
located at the right side). Advantage: What I like from the Volatility
Chart in this site is that the time-scale (in terms of months) in the
horizontal axis is very clear. Hence, it’s easier to make quick
comparison between months.
Disadvantage: The stock price is plotted separately from HV vs. IV.
Not too straightforward for analysis & comparison.

Picture courtesy of: www.ivolatility.com.

2) My options broker: OptionsXpress.

Here are volatility related tools / info I use from this site:

• Real-time IV figures for various strike prices and expiration months

(not only near ATM options).
• Options Pricer.
This tool can be used to calculate theoretical option’s price (options
 calculator), as well as to show the real-time Options Greeks data
(Delta, Gamma, Rho, Theta, and Vega).
• Volatility Chart.
This chart shows Historical Volatility (HV) and Implied Volatility
(IV) vs. Stock Price for 3 months, 6 months, and 1 year window.
Advantage: HV vs. IV vs. stock price, all plotted in one chart. It’s
easier for analysis & comparison (e.g. The reason why there is a
drastic surge in HV is because of the price gap up / down due to
earnings announcement).
Disadvantage: The time-scale (in terms of months) in the horizontal
axis is not very straightforward. Hence, it’s more difficult to make
quick comparison between months.

Picture courtesy of: www.optionsxpress.com.

How To Get Historical Volatility (HV) vs. Implied Volatility

(IV) Information – Part 2

Go back to Part 1.

How To Get HV and IV Info (Cont’d)

3) optionistics.com.
This site provides some tools & data such as:

• Option Chain: It provides IV as well as Options Greeks data (Delta,

Gamma, Rho, Theta, and Vega) for various strike prices and
expiration months (not only near ATM options).
• Options Calculator & Probability Calculator.
• Volatility Charts.
There are 2 types of Volatility Charts provided in this site (for 1 week, 1
month, 2 months and 3 months windows):

a) Stock Price vs. Implied Volatility (IV) chart.

This chart can be found under “Tools” >>“Stock Price History” at the left
bar.
However, this chart shows no Historical Volatility (HV), and the longest
window period of the chart is for 3 months only.

b) Option Price vs. IV chart.

This chart can be found under “Tools” >>“Option Price History” at the left
bar.
The good thing about this chart is that it can provide the Option
Theoretical Price & IV chart for various strike prices. As we’ll discuss
further in the future, Implied Volatility (IV) does vary by strike price.
On top of that, you can also select (from the drop-down menu) other
options greeks to be plotted with Option Theoretical Price in case you’d like
to analyze the trend of each greeks during the selected period of time.
To get the chart, simply type in the Option Symbol (e.g. APVJV is the
symbol for AAPL Oct 130 Call).
Pictures courtesy of: optionistics.com.

Relationship between Historical Volatility (HV) and

Implied Volatility (IV)

In the previous posts, we’ve discussed about the differences between

Historical Volatility (HV) and Implied Volatility (IV) and the sources /
websites to get such info.
In this post, we’ll talk further about the relationship between HV & IV.

What is the relationship between Historical Volatility (HV) and

Implied Volatility (IV)?
At a certain point of time, IV is hardly related to HV because IV represents
future expectations of stock price movement due to certain reasons, which
may not be reflected in Historical Volatility (HV).
Remember that IV is a prediction of stock’s volatility for the next 30
trading days, whereas HV is a measure of stock’s volatility over the past 30
trading days.
When we’re expecting some important events will happen in the next 30
days (e.g. earnings announcement, FDA approvals, etc.), IV will be
relatively high. But this may not be reflected in the “what has happened”
during the past 30 days. Hence, we can’t really compare or relate IV vs. HV
figures at a particular point of time.

Nevertheless, the highest, lowest & average points of HV usually might

provide some benchmarks for IV. Highly volatile stocks tend to have
relatively higher IV than less volatile stocks, because highly volatile stocks
have higher historical volatility as compared to less volatile stocks.

For example:
Picture courtesy of: www.ivolatility.com

As can be seen in the above pictures, AAPL’s IV numbers (gold colored

line) range between 24% to 54%, while its HV figures (blue colored line)
also fluctuate in about the same range.
In contrast, LMT’s IV varies between 15% to 35%, whereas its HV ranges
from 11% to 36%. (Before the recent sell-off starting from mid July, the IV
& HV only range between 15% to 24% and 11% to 24%, respectively. During
massive sell-off periods, volatilities normally increase across almost all
stocks, reflecting greater overall market uncertainties).
APPL is more volatile than LMT, as reflected in the Historical Volatility
figures, and consequently, AAPL’s Implied Volatilities are generally higher
than LMT.

There is no standard figure to determine if IV is high or low across all

stocks. Implied volatilities of a stock should be compared against its own
previous IV figures, not with the other stocks.
For example, IV = 34 can be considered very high for LMT, but it is
deemed quite low (average) for AAPL, when it’s compared relatively to its
individual stock’s past IV data.

More Understanding About Implied Volatility (IV)

In options trading, it’s crucial that one must understand the impact of
volatility on options pricing. Because it’s possible that the stock price has
moved profitably, but the option’s price did not.

Options Pricing & Implied Volatility (IV)

In options pricing, it is the Implied Volatility (IV) that affects the price of
an option, not Historical Volatility (HV).
IV has a huge impact on the option price. However, it is important to
highlight that IV affects only the time value component of an
option's price, not on the Intrinsic Value. Therefore, ATM (At-The-Money)
and OTM (Out-of-The-Money) options are the ones that will be greatly
affected by IV movement, as compared to ITM (In-The-Money) options.
How much IV changes affect an option’s price can be estimated from its
Vega.
To get data on Vega, as well as other options greeks (Delta, Gamma, Rho,
Theta) for various strike prices and expiration months, we’ve discussed it
before here.

How does IV influence an option’s price?

Assuming all factors remain constant:
An increase in IV will increase an option’s price (both Call and Put
options).
A decrease in IV will decrease an option’s price (both Call and Put options).

The reason is because higher IV implies that a greater fluctuation in the

future stock price is expected due to some reasons. And with greater
expected fluctuations, there will higher chances for an option to move into
your favor by expiration.
Therefore, when volatility is expected to be high (i.e. higher IV), option’s
prices will relatively be more expensive.

The Effect of IV on Option’s Buyer and Seller

As higher IV causes option price to rise (assuming other things constant),
an increase in IV would benefit option buyers, but will be disadvantageous
for option sellers (for both Calls & Puts).
On the other hand, a decrease in IV would have a negative impact on
option buyers, but will be beneficial for option sellers.

As a result:
When IV is relatively low and is expected to rise, buy options (i.e.
consider options strategies to take advantage of the expected move that
allow us to be an option buyer).

When IV is relatively high and is expected to drop, sell options

(i.e. consider options strategies to take advantage of the expected move
that allow us to be an option seller).

Implied Volatility (IV) For Various Strike Prices

IV is generally not the same for various strike prices, and also between Call
& Put options.
For the same expiration month, IVs vary by strike prices.
For some options, the IV of ITM & OTM options are higher ATM options.
Hence, when the IVs for various strike prices are plotted into a chart, it
would take shape approximately like a U-pattern, which is by glance, it
looks like a smile. As such, this is often known as “Volatility Smile”.
Other options may have higher IV for more ITM options and then it’s
decreasing as it moves towards OTM, or vice versa. Such pattern is called
“Volatility Skew”.
Basically, either Volatility Smile or Volatility Skew is typically used to
describe the general phenomena that IVs vary by strike price.
Picture courtesy of: riskglossary.com/link/volatility_skew.htm

How To Determine If An Option Is Cheap (Underpriced) Or

Expensive (Overpriced) – Part 1

As discussed before in the previous post, in options trading, Implied

Volatility (IV) has a huge impact on an option’s price.
An option’s price can move up or down due to changes in IV, even though
there is no change in the stock price.
Some times, for instance, we also find a stock price has gone up, however
the Call option of the stock did not increase, but it decreased instead. This
kind of case is not surprising if we understand the factors that affect an
option’s price. The reason why this phenomenon happens is usually due to
a drop in IV.

Therefore, before we buy or sell an option, it is important to check if an

option is relatively cheap (underpriced) or expensive (overpriced).
An option is deemed cheap or expensive not based on the absolute dollar
value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is expensive.
On the other hand, when the IV is relatively low, the option is considered
cheap.

How To Determine If IV is High or Low?

Often, we come across some articles which suggested the way to evaluate if
an option is cheap (underpriced) or expensive (overpriced) is by comparing
IV against HV at a particular point of time.
When IV is considerably higher than HV, it means an option is expensive.
On the contrary, when IV is much lower than HV, an option is considered
cheap.

However, the problem is that IV is hardly related to HV, because IV is a

prediction of stock’s future fluctuation for the next 30 trading days, while
HV is a measure of stock’s fluctuation over the past 30 trading days. IV
usually takes into account news or the coming important events. When an
important event is expected to happen in the next 30 days (e.g. earnings
announcement, FDA approvals, etc.), Implied Volatility will be relatively
high. However, this may not be reflected in the “what has happened”
during the past 30 days. Therefore, actually we can’t really compare IV vs.
HV figures at a particular point of time.

To determine if an option is cheap (underpriced) or expensive (overpriced),

IV figure at a particular point of time should be compared
against its past IV trend.
Typically, IV (and HV as well) will oscillate from a period of relatively low
volatility to a period of relatively high volatility. When IV is relatively high
or low, normally it will tend to move back towards its average value. This
pattern can be used to assess the reasonableness of an option’s price.

How To Determine If An Option Is Cheap (Underpriced) Or

Expensive (Overpriced) – Part 2

Go back to Part 1.

How To Determine If IV is High or Low? (Cont’d)

Example:

Picture courtesy of: ivolatility.com

For AAPL, the IV figures (gold colored line) range between 24% to 54%.
The peaks / highs of the IV charts are around 45% - 55%. When the IV is
relatively high for the stock, that means the option’s price is relatively
expensive.
On the other hand, the bottoms / lows of the IV charts are about 25% -
30%. When the IV is relatively low for the stock, that means the option’s
price is relatively cheap.
The area between 35% - 40% seems like the average area. Hence, when IV
is around this area, the option’s price can be considered quite “reasonable”,
not “expensive” or “cheap”.
Notice that when the IV is at the peak or at the bottom, it tends to move
back towards its average area.
Implied Volatility (IV) & Options Strategy Consideration
When IV is relatively low (option is cheap) and is expected to
rise, buy options (i.e. consider options strategies to take advantage of
the expected move that allow us to be an option buyer).
For example:
You expect the price to go up in the near term. Currently, the IV is also
relatively low and it’s expected to increase, as it is approaching earnings
announcement in a few weeks ahead. When you buy Call options, the
option’s price could increase not only due to the rising stock price, but also
as a result of the rising IV. Even when the price stays flat, the option’s price
might still increase due to the increase in IV.
Buying Straddle or Strangle also can benefit from the rising IV.

When IV is relatively high (option is expensive) and is expected

to drop, sell options (i.e. consider options strategies to take advantage
of the expected move that allow us to be an option seller).
For example:
When you’re bullish, you may want to consider a Bull Put Spread, which
allow you to sell options (and collect premiums) with a limited risk.
On the other hand, when you’re bearish, you can consider a Bear Call
Spread.

The Behavior of Implied Volatility (IV) & Historical

Volatility (HV) Before & After Earnings
Announcement

As mentioned before, Implied Volatility (IV) does factor in future

important events / news which are expected to move the option’s price
considerably within the next 30 trading days (e.g. earnings
announcement, FDA approvals, etc.).

For some regular events, such as earnings announcement, which typically

take place on a quarterly basis, we could see some common behavior before
& after the announcement.
Generally, IV would normally start to increase since a few weeks before the
announcement day.
Once the announcement is out, the IV will usually drop
significantly.
On the other hand, the Historical Volatility (HV) may rise
drastically should there were a significant gap up / down in
stock price after the announcement.

Example:
Note:
RIMM’s Earnings Announcement: 28 Sep 06, 21 Dec 06, 11 Apr 07, 28 Jun
07, 4 Oct 07.

As we can see from the chart, the IV (Implied Volatility) was normally
increasing when the announcement approached, and it dropped
significantly right after the announcement.

On the contrary, when there was a significant price gap (up / down) after
the announcement, the HV (Historical Volatility) increased drastically,
reflecting the sudden actual price movement (e.g. Price gapped up after
earnings announcement on 28 Jun 07).
Also notice that about 30 trading days after that, HV fell drastically. This is
because the price data on the day just before the price gap occurred has
been excluded from the HV calculation. (Remember that HV is a measure
of the fluctuations of the stock price over the past 30 trading days).

Example On How Implied Volatility (IV) Affects Option’s

Price Significantly
As discussed earlier, in options trading, Implied Volatility (IV) has a
considerable impact on an option’s price. An option’s price can go up or
down due to changes in IV, although there is no change in the stock price.
Some times, for instance, we also find a stock price has increased, yet the
Call option of the stock did not increased, but it dropped instead.
Now, let’s see a simple example on how IV affects an option’s price
considerably.

In the prior post, it’s shown that IV will normally begin to rise starting
from a few weeks before the announcement day. And once the
announcement is out, the IV will drop significantly.

The fact that the IV will drop considerably right after the announcement is
extremely important to note, particularly when you’re trading options by
buying straight call / put options (directional play) or buying strangle /
straddle (non-directional play) over earnings announcement.
This is typically the reason why you might see that the stock price has
gapped up / down in your direction, but yet the option’s prices do not move
profitably.
Why is it so?
Remember that, for both Call & Put options, an increase in IV will increase
an option’s price, whereas a decrease in IV would decrease an option’s
price.
(You may want to refer to the posts on Vega or Options Pricing for further
discussion).

The increase in IV before the earnings announcement is to “anticipate” the

volatility as a result of the announcement. In other words, certain
magnitude of the price movement (either up or down) has been “priced in”
by the increase in IV, which causes the option’s price to be more
“expensive” than normal.
Once the announcement is out, the IV will drop significantly, which would
affect the option’s price negatively.

Therefore, to be profitable in such cases, the increase / decrease in

stock price must be big enough to offset the negative impact of
the drop in IV on option’s prices.
And for strangle / straddle, the stock price movement must be even much
bigger in order to offset both the drop on option’s prices at both legs (call
& put legs) due to the drop in IV as well as the drop on option’s price at the
other leg after the stock price moves to certain direction.

Therefore, in this case, it’s important to first assess the Reward / Risk ratio
of a potential trade by inputting different scenarios of IVs and expected /
target stock prices (using Options Calculator / Pricer).
By doing this, you can anticipate what your best & worst scenarios are,
have your risk & return calculated, and determine if the trade is worth
taking.
What To Consider When You Are Buying An Overpriced
(High IV) Options

In the previous post, we discussed that when IV is relatively low (option is

cheap) and is expected to rise, we should buy options (i.e. consider options
strategies that allow us to be an option buyer).
On the other hand, when IV is relatively high (option is expensive) and is
expected to drop, we should sell options (i.e. consider options strategies
that allow us to be an option seller).

However, often we’d like buy options despite the relatively high IV (i.e.
options is considered expensive).
For example, for myself, I like playing directional swing trading to take
advantage the expected price movement for 1 – 3 days. Hence, in this case,
I’ll just buy straight call or put options depending on the expected
direction. However, frequently the option is relatively high in IV
(“expensive”). Is it all right if I buy the options?
To me, buying options when IV is high is still all right.
However, there are a few things to consider when buying options
with high IV:

1) As mentioned earlier, usually IV is high because we're expecting certain

events that can cause the drastic price movement (e.g. earnings
announcement, FDA approval, M&A, etc.). Before that event happens, the
IV normally will not drop drastically, and is also quite likely to rise even
higher and peak on the day of the event itself.
So, if I'd like to play swing trading or day trading, I have to make sure that I
close my position (sell the options) before the event take places.

2) Assess the Reward / Risk ratio of a potential trade by having

different scenarios of IVs, expected / target stock prices & time remaining
to expiration (using Options Calculator / Pricer).
By inputting different IV numbers (e.g. the highs, lows, or average, etc.) as
a parameter in the Options Calculator / Pricer, you can see how IV can
potentially affect your trade under different scenarios.
This could also help you to assess whether it’s better to use ITM (In-The-
Money), ATM (At-The-Money), or OTM (Out-of-The-Money) options.
As discussed previously on more understanding about IV, ATM and OTM
options are more affected by IV movement than ITM options.

(You can refer to the link for more discussion on how to get IV data)

3) Some traders like to bet with options over the events that can cause the
drastic price movement (e.g. earnings announcement, FDA approval,
M&A, etc.).
In this case, we have to bear in mind that some degree of price movement
has been priced in with the high IV. So, when IV drops considerably right
after the announcement, we can only gain if the price movement is big
enough to offset the drop in IV. Otherwise, we'll lose money with options
even though the stock price moves to the expected direction.
(As discussed more detail in this post).

4) When IV is relatively expensive and you don’t want your options to be

affected too much by the IV changes, you may want to consider buying
further ITM (In-The-Money) options.
Remember that IV has a considerable effect on the option price, but it
affects only the time value component of an option's price, not on the
Intrinsic Value
(Please refer to this post: More Understanding About Implied Volatility).
Therefore, the deeper ITM options will be less affected by the changes in
IV, as it has less time value component in the option price. The further ITM
an option, the lesser time value component it has.