Historical Volatility Demystified Part I

When most traders hear the word volatility, they typically think of how much a stock fluctuates in price. An oft used analogy in many financial cartoons is that of a roller coaster. What does a roller coaster help portray? Well it certainly causes one to think of the fast movements and large ups and downs. Volatility in this context could refer to the speed at which a stock moves or the magnitude of its swings. We call this type of volatility "historical volatility" or HV for short. In some texts historical volatility is referred to as statistical or realized volatility. All three terms usually refer to the same thing, so don't fret if they're sometimes used interchangeably.

The first thing to emphasize is that HV is derived from the stock price. Another frequently used measure of volatility, called implied volatility, is derived from option prices. This distinction is important so commit it to memory! Let's focus on the 'historical' part of historical volatility. HV can be thought of as a rear view mirror in that it looks backwards at a stocks history to derive its value. More specifically, as defined by Investopedia,

historical volatility "is calculated by determining the average deviation from the average price of a [stock] in [a] given time period."

So let's assume that we're comparing the HV of two $50 stocks, ABC and XYZ, for the last 30 days.

Using the above definition, suppose ABC had an average price of $45 over the last 30 days. Furthermore, in that time frame it rose as high as $60 and as low as $30. XYZ also had an average price of $45 over the last 30 days, but only rose as high as $53 and as low as $40.Which stock would you has has a higher HV? Did you guess XYZ? If yes, then re-read the prior paragraphs! If you guessed ABC, then congratulations keep reading. The answer is ABC because it deviated much more from its average price than XYZ.

Remember, stocks with low HV tend to move less, while stocks with high HV move more.

Next time we'll review the different lengths commonly used for HV.