Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Historical volatility (HV) measures the range of returns on a market index or security over a given time period. When an asset’s historical volatility is going up, that means its price is moving further away from its average (in either direction) more quickly than usual.
A stock’s historical volatility is commonly expressed as one standard deviation using daily returns, and it’s one factor that investors often look at to gauge the risk of a potential investment. An asset’s historical volatility is different from its implied volatility. Read on to learn what historical volatility is, how historical volatility works, and how to calculate historical volatility.
Key Points
• Historical volatility measures deviations from a stock’s average price over a period of time.
• The historical volatility of a stock is typically calculated using the standard deviation of daily returns.
• Historical volatility is expressed as a percentage, but differs from forward-looking implied volatility.
• High historical volatility suggests larger price swings, while low volatility indicates smaller movements.
• Traders may use historical volatility alongside implied volatility — which indicates the expected future volatility of an option’s underlying asset — to inform their trading strategy or assess a security’s riskiness.
What Is Historical Volatility?
Historical volatility measures how much the price of a stock or index goes up and down over a certain period. Investors calculate historical volatility by measuring how much an asset’s price deviates from its average price during a certain time period. Historical volatility typically looks at daily returns, but some investors use it to look at intraday price changes.
Analysts can use any number of trading days when calculating historical volatility, but options traders typically focus on a time period between 10 and 180 days to balance capturing short-term fluctuations with longer-term trends. Options traders may use historical volatility and implied volatility when analyzing trading ideas.
Historical volatility is typically expressed as a percentage that reflects the standard deviation from the average price, based on past price behavior. But there are also other methods they can use to determine an asset’s historical volatility. For example, unstable daily price changes often result in high historical volatility readings.
How Historical Volatility Works
Historical volatility, expressed as a percentage, tracks how much a stock’s price fluctuates in relation to its average price during a certain period. This is usually calculated using the standard deviation of past price returns, which is then demonstrated as an annualized figure.
When a stock sees large daily price swings compared to its history, it will typically have a historical volatility reading. Historical volatility does not measure direction; it simply indicates the deviation from an average.
When a stock’s historical volatility is rising or above average, it means daily price changes are larger than normal. When it is lower than average, a stock or index has been relatively calm.
How Historical Volatility is Calculated
The historical volatility formula is typically a standard deviation measurement. It typically takes a stock’s daily price changes and averages them over a period. There are several steps to calculating historical volatility:
1. Collect historical prices.
2. Calculate the average price over the chosen period.
3. Find the difference between each day’s price change and the average price.
4. Square those differences.
5. Find the sum of those squared differences (this finds the squared deviations).
6. Divide the sum by the total number of prices (this finds the variance).
7. Calculate the square root of the variance.
You can then calculate the annualized volatility of a stock in two ways:
• Daily returns: multiply the standard deviation by the square root of 252 (the approximate number of trading days per year)
• Monthly returns: multiply the standard deviation by the square root of 12 (the number of months per year)
Working through the historical volatility formula can be a lengthy process, but most brokerage platforms will automatically calculate it for you. Many brokers even offer historical volatility charts. With a historical volatility chart, you can easily compare changes through time.
For example, if a stock reacted sharply to an earnings release, its historical volatility charts may show a jump right after the earnings date, while implied volatility might drop sharply as the market makes adjustments to its expectations following the earnings results. Implied volatility measures market expectations of price fluctuations for a certain asset in the future, which is reflected in how its options are priced.
How to Use Historical Volatility
Traders may use historical volatility when analyzing a stock, fund, or index to get a sense of its riskiness. High or low historical volatility stocks are not inherently bullish or bearish. Day traders might seek high historical volatility stocks as candidates for high-profit trading opportunities (but they also come with high loss potential).
Traders sometimes use historical volatility to help set stop-loss levels, which are predetermined prices at which a trade will automatically close to limit losses. For example, a day trader might use three times a stock’s daily average range – a measure of historical volatility – to set a stop price. This is known as volatility ratio trading.
You can also use historical volatility to help determine whether a stock’s options are expensive to help determine an options trading strategy. If implied volatility is extremely high when compared to a stock’s historical volatility, traders may decide that options on the stock are undervalued and suitable as an investment.
Historical volatility can help traders understand the potential range of price movements, which may inform their risk management strategies and decisions about position sizing or exit points.
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Historical vs Implied Volatility
Like historical volatility, implied volatility measures fluctuations in an underlying stock or index over a period of time, but there are key differences between the two indicators. Implied volatility is a forward-looking indicator of a stock’s future volatility.
The higher the historical volatility, the more risk-prone the security has been in the past. Implied volatility, on the other hand, uses option pricing to arrive at a calculation and estimate of future volatility. If implied volatility is significantly less than a stock’s historical volatility, traders typically anticipate a relatively stable period of trading, and vice versa.
Typically, when implied volatility is low, options tend to also be priced lower, which may make them more appealing to buyers who seek to capitalize on potential future price movements. Sometimes investors will use a graph to determine how an option’s implied volatility changes relative to its strike price, using a volatility smile.
| Historical Volatility | Implied Volatility |
|---|---|
| Measures past price data to gauge volatility on a security. | Uses forward-looking option-pricing data to gauge expected future volatility on a security. |
| Higher historical volatility often leads to higher options pricing and higher implied volatility. | Imminent news, like a company earnings report or a key economic data point, may drive implied volatility higher on a stock or index. |
| May inform traders’ risk management strategies and decisions about position sizing or exit points. | Traders may use implied volatility to find stocks expected to exhibit the biggest price swings. |
The Takeaway
Historical volatility can be a useful indicator for both institutional and retail investors looking to monitor the level and frequency of a stock or index’s price fluctuations. It measures a security’s dispersion of returns over a defined period. Implied volatility is a similar tool, but it is forward-looking and uses option pricing to arrive at its output.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
FAQ
What is considered a good number for historical volatility?
It depends. Although one stock might have a high historical volatility reading, perhaps above 100%, another steady stock might have a low figure around 20%. The key is to understand the securities you trade. Historical volatility can be an indicator of a stock’s volatility, but unforeseen risks can make future volatility drastically different than the historical trend.
What is a historical volatility ratio?
The historical volatility ratio compares short-term and long-term historical volatility as a percentage of the price of a financial asset. You can interpret the historical volatility ratio by looking at short versus long historical volatility. If short volatility on a stock drops below a threshold percentage of its long volatility, a trader might think there will be a jump in future volatility soon.
This is similar to analyzing volatility skew in options. It is important to remember that the interpretation and technical rules of historical volatility can be subjective by traders.
How is historical volatility calculated?
Historical volatility calculations require finding the average deviation from the average price of an asset over a particular time. An asset’s standard deviation is often used. Historical volatility is usually stated as one standard deviation of historical daily returns.
Many trading platforms automatically calculate historical volatility, so you may not have to do the calculations manually.
Photo credit: iStock/Eva-Katalin
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