Understanding the difference between implied volatility (IV) and historical volatility (HV) is crucial for options traders. These two measures tell you different things about a stock's price behavior and can help you identify trading opportunities when they diverge.
What is Historical Volatility?
Historical volatility (HV), also called realized volatility or statistical volatility, measures how much a stock's price has actually moved in the past. It is calculated using historical price data and expressed as an annualized percentage.
The simple version: Historical volatility looks backward. It tells you how much the stock actually moved based on past prices. If HV is 30%, the stock has been moving at a pace that would result in a 30% annualized price range.
How HV is Calculated
Historical volatility is calculated by:
- Taking daily price returns (percentage changes)
- Calculating the standard deviation of those returns
- Annualizing the result (multiply by square root of 252 trading days)
Common lookback periods include 10-day, 20-day, 30-day, and 60-day HV.
What is Implied Volatility?
Implied volatility (IV) measures how much the market expects a stock to move in the future. It is derived from current option prices using an options pricing model like Black-Scholes.
The simple version: Implied volatility looks forward. It tells you how much traders expect the stock to move based on what they are willing to pay for options. Higher option prices mean higher implied volatility.
How IV is Derived
Implied volatility is "implied" from option prices:
- Take the current market price of an option
- Plug all known variables into an options pricing model
- Solve for the volatility that makes the model price equal the market price
- That volatility is the implied volatility
Key Differences: IV vs HV
Comparison Table
- Historical Volatility: Backward-looking, based on actual price data, objective calculation
- Implied Volatility: Forward-looking, based on option prices, reflects market expectations
Direction of View
- HV: Tells you what DID happen
- IV: Tells you what the market EXPECTS to happen
Data Source
- HV: Calculated from stock prices
- IV: Derived from option prices
Objectivity
- HV: Objective - same calculation always gives same result
- IV: Subjective - reflects collective market sentiment
The IV-HV Relationship
Comparing IV to HV reveals valuable trading signals:
When IV is Higher Than HV
This means the market expects more volatility than the stock has recently shown. Options are relatively expensive.
- Common before earnings, FDA decisions, or other events
- Favors premium selling strategies
- Market may be overpricing expected moves
When IV is Lower Than HV
This means the market expects less volatility than recent price action. Options are relatively cheap.
- Often occurs after a period of high volatility is calming
- Favors premium buying strategies
- Market may be underpricing expected moves
Trading the IV-HV Spread
Many professional traders look for large discrepancies between IV and HV:
Strategy: Sell Premium When IV > HV
When implied volatility significantly exceeds historical volatility:
- Sell iron condors or credit spreads
- The inflated IV will likely mean-revert
- You collect extra premium from the elevated IV
Example
Stock XYZ has 20-day HV of 25% but IV of 45% before earnings:
- IV is 80% higher than HV
- Options are expensive relative to recent movement
- Consider selling an iron condor to capture the premium
- After earnings, IV will likely crush toward HV levels
Strategy: Buy Premium When IV < HV
When implied volatility is below historical volatility:
- Buy straddles or debit spreads
- Options are cheap relative to actual stock movement
- A catalyst could push IV back above HV
IV Percentile and IV Rank
To better contextualize IV levels, traders use IV percentile and IV rank:
IV Percentile
Tells you what percentage of days in the past year had IV lower than today's IV. An IV percentile of 80% means IV is higher now than 80% of the past year.
IV Rank
Compares current IV to the high and low IV over the past year:
IV Rank = (Current IV - 52-week Low IV) / (52-week High IV - 52-week Low IV)
Both metrics help you understand if IV is high or low relative to its own history.
Using HV for Position Sizing
Historical volatility helps determine appropriate position sizes:
- Higher HV stocks need smaller positions to maintain consistent risk
- Use HV to estimate expected daily moves
- Adjust stop losses based on recent volatility
Expected Daily Move
If HV is 32%:
- Annual expected move = 32%
- Daily expected move = 32% / sqrt(252) = 2%
- A $100 stock would have typical daily moves of about $2
Common Mistakes to Avoid
- Assuming IV will match HV: IV and HV can diverge for extended periods
- Ignoring event risk: High IV before events is often justified
- Using wrong HV timeframe: Match your HV lookback to your option expiration
- Forgetting regime changes: Past volatility may not predict future volatility in changing conditions
Which Volatility to Use When
Use Historical Volatility When:
- Estimating realistic price ranges
- Setting stop losses and profit targets
- Determining position sizes
- Backtesting strategies
Use Implied Volatility When:
- Pricing options or evaluating if they are cheap/expensive
- Choosing between buying or selling premium
- Selecting strategies based on volatility outlook
- Understanding market sentiment
Monitor Volatility Across Your Portfolio
Pro Trader Dashboard tracks both implied and historical volatility for your positions, helping you identify opportunities when IV and HV diverge.
Summary
Historical volatility tells you how much a stock has moved in the past, while implied volatility reflects how much the market expects it to move in the future. When IV exceeds HV, options are expensive and selling premium is favored. When IV is below HV, options are cheap and buying premium makes more sense. Understanding both metrics and their relationship is essential for successful options trading.
Ready to learn more about volatility? Check out our guide on volatility crush or learn about the volatility smile and skew.