When figuring out the true value of an option, volatility can be the most important factor that will influence the options price over it's lifetime. At the fundamental level, volatility means movement of the underlying asset. But when it comes to options, volatility is a bit more complex than simply measuring the movement of the stock or any other asset that you may want to analyze.
There are two main types of volatility: historic and implied and understanding the difference between the two and the basic principles of each can go a long way to help you become a successful options trader.
Historic volatility, is displayed as a percentage and measures how much the asset moved on a daily basis over a specified period of time in the past. To give you a simple example, assume that you are looking at a stock that's priced at $20.00 per share and has an average daily trading range over the past 4 month of $0.50 on average. This means that the volatility over the past 120 days was approximately 2.5%, which is considered to be fairly low historic volatility. If on the other hand the volatility was 20% or 30% over 120 days, the historic volatility would be high.
When a particular stock has higher historic volatility, the price of the option would be higher, because a stock that that moves substantially over time, has a higher chance of continued movement, which is what the option buyer wants. Conversely, when a stock has low historic volatility, the option would have a lower price, because there's a lower chance that the option will move substantially and as a result the option buyer has less chance to profit.
As a practical example, tech stocks such as Apple and Amazon have much higher historic volatility than blue chip stocks for example, since tech stocks are naturally more volatile than blue chip stocks and have a higher chance of movement over time.
Often times traders buy and sell options based on historic volatility, even though they are making a decision that's based on what already happened in the past. While the past never repeats itself the same way, it can give a good indication of how the underlying asset may behave going into the future.
Implied volatility on the other hand is derived directly from the option’s actual market price and shows what the market “implies” about the underlying assets volatility going in the future.
Without getting into complicated theory, implied volatility is also displayed as a percentage, is based on what the market believes at any given time the option is worth. Historic volatility can always be directly measured, but implied volatility is derived from the options price and is based on what the market is willing to pay for the option at any given time.
Implied volatility is determined by an options pricing model. it cannot be determined by looking at the underlying asset like historic volatility. Implied volatility is one of several variables used in an options pricing model, but it’s the only one that is not directly ascertainable by looking at market price. Implied Volatility can only be determined by knowing all the other variables and solving it for implied volatility, by using a model.
Since the majority of option trading volume occurs in at-the-money options, these are the options that are generally used to calculate Implied Volatility. Once we know the price of the at the money options, we can use an options pricing model and a math formula to solve for the implied volatility of that particular option.
Higher implied volatility levels reflect a higher expected fluctuation in the underlying asset, while lower implied volatility levels reflect a lower expected fluctuation in the underlying asset.
To ascertain implied volatility levels on a particular stock, you need to have access to a pricing model, the most common one is called the Black-Scholes model. Fortunately, majority of options brokerage firms offer clients trading software that provides access to this options model. To utilize the model, you will have to enter the variables that can be ascertained including: stock price, strike price, interest rate, dividend, expiration date and the actual price of the option. (Most options chains include implied volatility without you having to enter this data manually).
You will often find that options that have high implied volatility tend to have wider bid-ask spreads than options with low implied volatility levels. This occurs because high implied volatility levels don't give clues as to the future direction of the underlying asset, it only gives indication of the degree of potential movement over time; this increases speculation in both directions and ultimately widens the spread between the bid and offer.
To summarize the key difference: Implied volatility is forward-looking while historical is backwards looking.