Volatility is a measure of how fast the underlying futures prices are moving. It is a measure of the speed and magnitude at which the underlying stock’s prices change. This is expressed in a percentage. The two basic types of volatility are historical volatility and implied volatility. Historical volatility is a measure of how much the prices have been fluctuating in the past. Implied volatility is the option market’s assessment of how volatile the prices would be in the future. Implied volatility is a barometer of the collective thought process about the price fluctuation of the underlying. If the market is highly volatile then, the premium on options would surge because the traders become skeptical that price of the underlying may move in a different direction. Therefore, they increase option premiums to compensate for this perceived risk. If the investors think that the volatility will go up, then they should buy options irrespective of the direction of the movement of the market. On the other hand if the investors think that the volatility will go down, then they should sell options.
Historical volatility is the measure of actual price changes to an underlying asset over a specific period in the past. Stated in simple terms, historical volatility is the standard deviation worked out for the underlying for any defined period of time which could be a week, a month, a quarter or even a year. Historical volatility can be computed for the closing prices, weighted average prices of the underlying, etc.
As the name suggests, this is the volatility implied by the market based on the market rates of the underlying and the rates of the option contracts. Given the various parameters that go into the pricing of the options, the volatility that is assumed in the pricing model can be easily derived. The theoretical volatility derived from such a computation is the volatility that the market implies or other wise known as implied volatility. This is bound to be different from the historical volatility as the historical volatility is based on the past data and the implied volatility is based on the present and perceived future conditions of the market.
Factors influencing implied volatility
The price of option like any other product is predominantly determined by the supply and demand for the product. The market makers who play a vital role in maintaining the balance between the supply and demand adjust the spread for the option product. When the demand for an option is more than the supply, then the market makers increase the price of the product and vice versa. The increase or decrease in the price of the product abruptly ceteris paribus, reflects the change in the implied volatility of the market for that product.