The discussion of volatility reminds many option traders of that dreaded, grade point wrecking statistics course in college. Well you made it through and will now learn to apply it. Please do not forgo learning this because many low risk, high profit option trading strategies are based on volatility.
Historical volatility is the annualized standard deviation of stock price movements.
Note in that definition that both time and price change are used. Historical volatility measures how much and how fast prices have changed in the past. Since it is based on past prices, it is a historical measure and is thus referred to as historical volatility.
Implied volatility is the market forecast of historical volatility in the future.
Many traders make the mistake of assuming high historical volatility signals a trending market and low historical volatility signals a side-ways market. I found this statement regarding historical volatility on another web site:
“When historical volatility is high, it says that the stock has been showing extreme fluctuations in price. When it is low, it suggests quiet or sideways trading.”
The first statement regarding high historical volatility is correct. You should note it does not mention direction or trending prices. However, low historical volatility can occur when price makes a parabolic move. For example, if a $50 stock moves up 0.5% per day for a year, the historical volatility is zero while price moved up to $179.26. If a $50 stock moved up 0.5% one day and then down 0.5% the next day and alternated this for a year, the historical volatility is 0.5% while price moved from $50 to $49.84. The way you would trade these markets using options is very different although both have extremely low historical volatility.
This shows the difference between historical volatility and implied volatility. The implied volatility during a parabolic move can be extremely high while historical volatility is low.
Historical volatility is a pure mathematical calculation based on past stock data while implied volatility is a market forecast based on assessment of risk in the future as reflected in the option price.
Learning to use implied volatilities in your trading will add a new list of strategies to your option-trading arsenal.