Volatility is at the heart of options pricing, but there are two fundamentally different types that traders must understand. Historical volatility looks backward at what happened. Implied volatility looks forward at what the market expects. Knowing the difference can make or break your options trades.
What is Historical Volatility?
Historical volatility (HV), also called realized volatility or statistical volatility, measures how much a stock's price has actually moved over a past period. It is calculated from historical price data.
Simple definition: Historical volatility tells you how volatile a stock has been. If a stock moved 2% per day on average over the past month, that is its historical volatility.
How Historical Volatility is Calculated
The calculation involves several steps:
- Calculate daily returns (percentage changes) for a period
- Find the standard deviation of those returns
- Annualize the result by multiplying by square root of trading days (typically 252)
Example
A stock has daily returns of +1%, -0.5%, +2%, -1%, +0.5% over five days.
The standard deviation of these returns is about 1.12%.
Annualized: 1.12% x sqrt(252) = 17.8% historical volatility.
Common Historical Volatility Periods
- 10-day HV: Short-term, recent volatility
- 20-day HV: About one trading month
- 30-day HV: Standard comparison period
- 60-day HV: Medium-term volatility
- 252-day HV: One trading year
What is Implied Volatility?
Implied volatility (IV) is the market's expectation of future volatility, derived from current option prices. It is not calculated from historical data but rather extracted from what traders are willing to pay for options.
Simple definition: Implied volatility tells you how volatile the market expects a stock to be. If options are expensive, IV is high because traders expect big moves.
How Implied Volatility is Calculated
IV is derived by working backward from option prices using an options pricing model (like Black-Scholes):
- Take the current option price
- Input all known variables (stock price, strike, expiration, interest rate)
- Solve for the volatility that makes the model price match the market price
- That volatility is the implied volatility
Key Differences at a Glance
| Aspect | Historical Volatility | Implied Volatility |
|---|---|---|
| Time Orientation | Looks backward | Looks forward |
| Data Source | Historical prices | Current option prices |
| Calculation | Standard deviation formula | Derived from options pricing model |
| What it Tells You | What happened | What market expects |
| Changes | Updates as new prices come in | Changes with option supply/demand |
Why the Difference Matters
The relationship between HV and IV creates trading opportunities:
When IV is Higher Than HV
Options are relatively expensive. The market expects more volatility than has recently occurred. This often happens:
- Before earnings announcements
- Before major news events
- During periods of uncertainty
Trading implication: Selling options may be advantageous because you collect high premium.
When IV is Lower Than HV
Options are relatively cheap. The market expects less volatility than has recently occurred. This might happen:
- After a volatile period calms down
- During low-news periods
- When complacency sets in
Trading implication: Buying options may be advantageous because they are cheap.
Trading Example
Stock XYZ has 30-day historical volatility of 25%. Implied volatility for 30-day options is 40%.
This means options are pricing in 60% more volatility than the stock has actually shown. If you believe the stock will continue trading calmly, selling options could be profitable as IV will likely compress toward HV.
Using HV and IV Together
Volatility Premium Analysis
The difference between IV and HV is called the volatility risk premium. Studies show that IV tends to overestimate future volatility on average. This is why option sellers can be profitable over time.
Comparing Different Periods
- Compare 30-day IV to 30-day HV for a direct comparison
- Look at 10-day HV to see very recent realized moves
- Compare IV across different expirations to understand term structure
Charts and Visualization
Many platforms show IV and HV overlaid on charts. Look for:
- IV spikes above HV (options are expensive)
- IV drops below HV (options are cheap)
- Convergence patterns after divergence
Practical Trading Strategies
High IV, Low HV (Sell Premium)
- Sell iron condors
- Sell credit spreads
- Sell strangles (with caution)
- Write covered calls
Low IV, High HV (Buy Premium)
- Buy straddles or strangles
- Buy debit spreads
- Buy long calls or puts
IV Equal to HV (Neutral)
- Focus on directional trades
- Consider calendar spreads
- Wait for better opportunities
Common Misconceptions
Misconception 1: IV Predicts Direction
IV tells you about expected magnitude, not direction. High IV does not mean the stock will go down. It means the market expects a big move, up or down.
Misconception 2: HV is Always Right
Just because a stock has been calm does not mean it will stay calm. News, earnings, or market events can suddenly increase volatility. HV looks backward; do not assume it predicts the future.
Misconception 3: High IV Means Options Are Overpriced
High IV reflects market expectations. If a company is about to announce earnings, high IV might be justified. IV can be high and still be "correct" if actual volatility turns out to match expectations.
Key insight: IV is not right or wrong until after expiration. Only then can you compare what was implied versus what actually happened (realized volatility).
Tools for Tracking HV and IV
- Most trading platforms show IV on option chains
- ThinkorSwim has extensive volatility tools
- CBOE provides VIX and other volatility indices
- Third-party sites like Market Chameleon track IV
- Many platforms overlay HV and IV on charts
Track Your Options Performance
Pro Trader Dashboard helps you analyze how volatility affected your trades and improve your results.
Best Practices
- Always check both HV and IV before entering options trades
- Use IV percentile/rank to contextualize current IV levels
- Consider upcoming events that might justify high IV
- Do not assume IV will immediately converge to HV
- Track your trades to see how volatility affected outcomes
Summary
Historical volatility measures past price movement, while implied volatility reflects market expectations of future movement. The relationship between the two creates opportunities: sell premium when IV exceeds HV, buy premium when IV is below HV. Neither is inherently right or wrong; they simply tell different stories. Smart traders use both together to make informed decisions about options strategies and position sizing.
Learn more about IV Rank or read about implied volatility basics.