Friday, September 11, 2009

Historical Volatility Demystified Part IV

We've finally reached the conclusion of our short, yet to some too long, expedition into the volatility arena. As I often provide commentary on HV, I thought it useful to offer an in depth overview of its different nuances. So with out further ado, here's part IV.

After understanding the basic definitions and nuances of how historical volatility is calculated, most traders naturally wonder how to determine whether it is high or low. The first thing to recognize is there are no absolute levels that are considered “high” or “low” for HV. Each individual index or stock exhibits varying levels of HV. High HV for Wal-Mart (WMT) may very well be low HV for Apple Inc. (AAPL). The most common method for determining whether HV is high or low is comparing current HV levels to a historical range of HV levels. For example, over the last year the 30 day HV of AAPL has ranged between 23% and 107%. Because the current level of 30 day HV resides at 26%, it is fair to say that it is low (click to enlarge).

[Source: EduTrader]

Wal-Mart, a considerably less volatile stock, has seen its 30 day HV range between 64% and 11%. Like Apple, Wal-Mart’s 30 day HV currently resides at the lower end of its yearly range. Thus, it’s also fair to say that WMT HV is currently low (click to enlarge).

[Source: EduTrader]

The primary reason WMT and AAPL are being used as examples is because they come from two completely different sectors. AAPL resides in the technology sector which historically is a more aggressive, volatile space to trade in. WMT, on the other hand, resides in the consumer staples sector which is historically a more defensive, less volatile space to trade in.

Now that you've ingested a healthy does of HV theory, let's get specific on the application piece of the puzzle. For stock trading, a simple (and hopefully obvious) approach is to use HV as a measure of risk. Because stocks with higher levels of HV are undoubtedly more volatile, they require a higher risk tolerance. If you’re risk averse and abhor trading volatile stocks then steer clear of those that possess higher HV. As you’re building your watch list of stocks you’d like to trade, it may be prudent to assess HV and make sure it's within your comfort zone.

In addition to using HV as a gauge of risk, option traders typically utilize HV to help in gauging whether or not options are cheap or expensive. In subsequent articles we'll elaborate on this method...