Historical Volatility
Definition
Historical volatility is a statistical measure used to analyze the general dispersion of security or market index returns for a specified period of time. It is commonly calculated by identifying the average deviation from a financial instrument’s average price within the set time period. Options traders use historical volatility to calculate the probabilities of their trades.
Volatility is often called the fear gauge, but that is not the case at all and a misrepresentation as it primarily conveys sudden change in price or the rapid changes occurring. More often than not, historical volatility is calculated by using standard deviation, but there are many other ways of calculating the measure. Note that the higher the historical volatility value, the higher the security risk. Understanding that risks can be both bearish and bullish, the results are not necessarily something to be overly wary of.
Takeaways
Historical volatility is mainly used to measure the distance a security’s price moves in relation to it’s mean value. However, it can be used to measure other specifics as well, including loss probability.
Historical volatility can be used to measure how far index prices move away from the moving average for trending markets, which is how a strong trend can show a low volatility value while prices change drastically. The value doesn’t fluctuate on a daily basis, rather steadily changes over time with the market trend.
Although used to measure price movements, historical volatility also helps analyze all different types of risk valuation and tolerance. High historical volatility may require higher risk tolerance than its lower value counterparts. This inherently calls for alterations to the measure, whether that be stop-loss level changes or margin requirement adjustments.
What to look for
Although volatility doesn’t sound all too great, many traders and investors make decent profits with high volatility. With low volatility also comes the low potential of making capital gains, which occurs when a stock or security isn’t mobile. With high volatility, there comes the constant gamble of high risk, high reward. Losses, however, can be crippling, which means trades must be calculated down to the millisecond and timing has to be perfect.
For smooth sailing, it is best if volatility levels are calculated in the middle ground - not too high, not too low. It’s difficult to say where that middle ground is, as it varies depending on the specific market and, even more particularly, on the specific stock. By comparing the volatility with other securities and by using a combination of technical analysis indicators, a middle ground for volatility levels shouldn’t be too hard to find.
Summary
Historical volatility measures the changes of security prices in a market over a specified period of time. It can be used to measure risk and traders often use it to analyze and determine the status of market trends. High volatility is often associated with negative connotations, but this is not always the case, as we’ve learned above. If you’re not ready to gamble, finding a neutral ground when it comes to historical volatility is a good place to start with your trading.