Volatility is a statistical measurement of the degree of fluctuation of a market or security. Volatility is computed as the annualized standard deviation of daily percentage price changes of the security and is expressed as a percentage.
Historical Volatility (HV)
Historical volatility measures how volatile the security has been in the past. To compute historical volatility, you must first define a look-back period. Twenty day periods are commonly used as it approximates the number of trading days in a month.
Implied Volatility (IV)
Implied volatility is the volatility as implied by the market price of the security's options. The implied volatility is calculated using an option pricing model, such as the Black Scholes model, in which a mathematical relationship between the volatility of the underlying security and the price of its options has been established.
In other words, implied volatility is the market's opinion of the volatility of the option's underlying security and is determined using the following information:
- The price of the underlying security
- The market price of the option
- The strike price of the option
- The expiration date of the option
- The interest rate, if applicable
- The dividend yield, if applicable
In theory, for options expiring on the same date, we expect the IV to be the same regardless of which strike price we use to perform the calculation. However, in practice, the implied volatilities we obtain varies across the various strikes, giving rise to what is known as the volatility skew.
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