A volatility chart tracks the volatility ÃƒÂ¢Ã¢â€šÂ¬Ã…â€œlevelÃƒÂ¢Ã¢â€šÂ¬Ã‚Â over time for both historical volatility [HV] and implied volatility [IV]. It is a helpful visual aide because it makes it easy to compare HV with IV both currently and over time. Though these are helpful aides, they are often misinterpreted by novice traders with unfortunate consequences. Volatility charts are one area where knowing just enough to be dangerous can be, well, dangerous.
Traders must perform three separate analyses. First, compare current IV with current HV. This gives an indication of how the market is pricing volatility into option prices in comparison with recent stock volatility. If the two are significantly different, an opportunity may exist to buy or sell volatility at a favorable level. Generally, if IV is above HV this is the first indication that option prices may be high. Likewise, if IV is below HV, this may mean option prices are cheap.
[BAC volatility chart. click for larger view.]
But to be sure, traders must also compare current IV with past IV. This helps a trader understand whether IV is comparatively high or low in relative terms. If implied volatility is higher than normal it may be expensive, warranting a sale; if it is lower than normal it may be a cheap buy.
Finally, traders need to complete their analysis by also comparing current HV with past HV. HV on the volatility chart can give an indication as to whether recent stock volatility has been greater or lower than normal. If current HV is higher than it was on average in the past, the stock is showing that it is more volatile than normal.
If the price at which an option can be traded (in terms of IV) doesnÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢t support the higher stock volatility, the trader must trade accordingly. That is, if IV is very low, as HV is higher than normal, it may be a buy signal. Conversely, if HV has fallen below normal levels, traders need to observe IV to see if an opportunity to sell volatility exists. If IV is high in this HV setup, it could be a volatility sell signal.
Click Here for Analyzing Volatility Part I: Historical Vs. Implied Volatility
Category: Trading Education