What Is Historical Volatility (HV)?
Historical volatility (HV) measures the changes in underlying securities over a given period. One could measure the HV by calculating how much the average price of a financial instrument varies. However, there are other methods. A higher value of historical volatility indicates a higher risk in security.
Understanding Historical Volatility (HV)
Historical volatility doesn't measure the chances of loss. It gauges how much a security's price deviates from its mean value.
Likewise, historical volatility gauges how much the traded price deviates from the cost, moving average, or central average. It indicates how a smooth and trending market could have low volatility despite the dramatic price change. Its price remains mostly the same from day to day but rather steadily over time.
Historical and implied volatility are often compared for the determination of option prices. This comparison helps us know if options prices are undervalued or over-valued. Another use of historical volatility is in risk valuations. There is a need for high-risk tolerance for stocks with high historical volatility.
Additionally, markets with high volatility necessitate broader stop-loss levels and perhaps greater margin requirements.
Historical volatility (HV) is frequently utilized as an input in technical studies other than options pricing, including Bollinger Bands. Standard deviation variations in volatility cause these bands to shorten and expand around central deviations.
Using Historical Volatility
Although volatility has a negative connotation, many traders and investors can potentially benefit from higher volatility by generating more profits. Since a stock doesn't move, it has low volatility. However, its potential to make capital gains will decrease.
On the other hand, the profit potential of a stock with high volatility will be increased. Likewise, it would also have higher loss potential. Even a good market prediction could result in a loss if the security's large price movements cause a margin call or stop-loss.
You can determine these average volatility levels by comparing different peer securities.
Implied Volatility vs. Historical Volatility: An Overview
Volatility measures the fluctuation in security prices. In simple words, higher volatility indicates higher risk and, hence, higher potential benefits. On the other hand, low volatility suggests a low premium for options. Therefore, it's essential to understand the security price fluctuations before making a trade.
In an options trade, both parties consider the underlying security's volatility. Normally two methods help in measuring the volatility.
a. Historical volatility
b. Implied volatility
Implied volatility indicates what to expect about future volatility. On the other hand, historical volatility determines the past trending ranges of the underlying indexes and securities.
These matrices can collectively affect the options prices. It has a frequent impact on time value. Time value normally changes with volatility.
