Derivatives

What is the difference between historical and implied volatility

Akhil Nallamuthu | Updated on April 17, 2021

When it comes to trading, it is imperative to understand the concept of volatility. Volatility is the amount of variation of a price of a security over a particular time irrespective of the direction. It is also considered a measure of risk i.e., a security with higher volatility is deemed to be riskier i.e., it can undergo a considerable amount of change in price. But that is where the opportunity lies as well. There are two types of volatility i.e., historical volatility (HV) and implied volatility (IV).

Historical volatility of a security tells us about how volatile it has been in the past over a particular period i.e., it is backward looking. Importantly, HV can change based on the time period that we look into. For instance, HV of a stock in last one year and in last six months can be different say, 15 per cent and 10 per cent respectively. The inference is that the stock has turned less volatile of late. Importantly, this may not be a good indicator of future volatility.

Implied volatility (IV) is the assumed or the estimated volatility i.e., it indicates the level of volatility that the market expects going forward. IV is calculated using the price of option contracts of that security. For example, India VIX is the measure of IV of Nifty 50, which shows the market expectations of volatility in the index over the next 30 calendar days. It is calculated using prices of out-of-money option contracts. But generally, IV has always overstated the actual volatility.

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Published on April 17, 2021

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