Implied and Historical Volatility
There are two types of volatility that you need to understand for options trading: historical volatility and implied volatility.
Remember that there are 7 variables that affect an option's premium. Six of these variables are known with certainty: (1) stock price; (2) strike price; (3) type of option; (4) time to expiration; (5) interest rates; (6) dividends.
The final variable is not known with certainty and is the expected volatility of the stock. This expected volatility figure is expressed as an annualised standard deviation and, working back
from the option premium itself, is an "implied" figure, hence implied volatility. historical volatility is the annualized standard deviation of past price movements of the stock. We use historical volatility as
a reference figure for calculating what the fair value of the option should be, given the stock's historical volatility. In the real world, option premiums frequently trade away from their fair values.
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Volatility
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Historical (or statistical)
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Based on the underlying asset volatility over past (20-23 trading days is popular)
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Expressed as a % reflecting the average annual range (ie standard deviation)
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Implied
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Based on the option's actual price (premium), expressed as a % and based on the perception of where market will be in the future
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This is the volatility figure derived from the Black-Scholes options pricing formula
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Look for
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Comment
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Implied > Historical
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Options premiums could be overvalued as a result of higher implied volatility (look to sell options)
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Historical > Implied
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Options premiums could be undervalued, indicating good buying opportunities, particularly if you anticipate asset price movement
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Generally, implied volatility will veer towards Historical over the medium to longer term - this is known as the "rubber band effect"
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Bollinger Bands are a good visual representation of volatility
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