Last Updated on 12 June, 2021 by Samuelsson
If you have been an active day trader, you would agree with me that volatility is like a double-edged sword. You need enough of it to be able to make some money from the market, but the higher it gets, the more the risk of being stopped out. As retail traders, we are mostly used to historical volatility, but what does this historical volatility mean?
Historical volatility is a statistical measure of the distribution of returns for a given security or market index over a specified period. It is estimated by calculating the average deviation of the instrument from its average price and finding the standard deviation. Volatility is used to measure the riskiness of an asset: an increase in volatility implies an increase in risk and uncertainty, while a decrease in volatility indicates lower risk and uncertainty.
To make the topic easier for you to understand, we will be discussing it under the following subheadings:
- What does historical volatility mean?
- How is historical volatility calculated?
- Other indicators you can use to estimate historical volatility
- What is the difference between historical volatility and implied volatility?
- How do you interpret historical volatility?
- How do you trade historical volatility?
What does historical volatility mean?
Historical volatility (HV, for short) is a statistical indicator that measures the extent to which the price deviates from its average in a given period. The more the change in price, the higher the indicator value. It is important to note that historical volatility does not measure the direction of the price change, but just how much the price fluctuates.
Volatility is a measure of risk — the higher the volatility in a financial instrument, the more risky it is to invest in and vice versa. In trading, volatility is often associated with big swings in price in either direction. For instance, when there’s a rise and fall of more than one percent in a short period of time, the market is said to be ‘volatile’. The volatility of an asset is an important factor when pricing the options contract, as traders try to determine the risk associated with the investment.
Unlike implied volatility that tries to measure expectations of future volatility, historical volatility is estimated from past price movements, and traders it to identify instruments that have been volatile in the past. HV can be used with other indicators, trading patterns, and trends to not only identify instruments that are considered to be risky or highly volatile but also improve overall trading results.
HV can be used in all types of risk valuations. Apart from identifying instruments with high historical volatility, which usually require a higher risk tolerance, it helps the trader to estimate the right size of stop loss for different market conditions — a market with high volatility would require wider stop-loss levels. Furthermore, HV is often used in other technical indicators that measure volatility such as Bollinger Bands, which narrow and expand around a central average in response to changes in volatility measured by standard deviations.
It’s important to note that HV does not directly measure the chances of getting a loss, although it can be used to indicate that. In a strongly trending market, HV can provide an overview of how far the prices fluctuate from the moving average price. If volatility is low, the prices would be close to the moving average as they advance in the trend direction. The value of HV may not change significantly on a daily basis but the changes are usually consistent.
To check whether instruments may be undervalued or overvalued, the HV and implied volatility are compared to one another. But HV is the more common measure used in risk assessment and valuations.
How is historical volatility calculated?
There are many ways to measure volatility and each trader has their ways and tools for measuring it. Here, we are focusing on historical volatility, which is normally calculated as a standard deviation of price distribution about its moving average.
To calculate HV:
- First, find the prices for the financial instrument over the period you want to study.
- Calculate the average of the historical prices.
- Calculate the difference between the average price (mean) and each price in the series.
- Square the difference from the above step.
- Determine the value of the sum of the squares of the differences.
- Divide the difference by the overall total number of prices (then find the variance).
- Calculate the square root of the variance that was computed in the previous step.
Other indicators you can use to estimate historical volatility
Apart from measuring the standard deviation of price distribution around its moving average, there are simple indicators traders and financial analysts use to estimate historical volatility in a market. The most common ones are:
- Bollinger Bands
- Average True Range
The Bollinger Bands
The Bollinger Bands is a technical indicator that was developed in 1980 by the famous technical trader, John Bollinger, to help traders spot when a security is probably overbought or oversold; however, because it makes use of mean price and standard deviation, it is an effective tool for estimating the level of volatility in the security.
Bollinger bands consist of three lines:
- The central line is a 20-period moving average which actually measures the mean price
- The upper band is a line plotted 2 standard deviations above the moving average
- The lower band is a line plotted 2 standard deviations below the moving average
In the chart below, you can see that the indicator shows both the mean price and the 2 standard deviations away from the mean. Since standard deviation is a measure of volatility, the bands move in a way that reflects changes in volatility: when volatility is increasing, the bands expand, reflecting the increase in variability of the price data, and when volatility is decreasing, the bands constrict to reflect the reduction in variability.
Average true range (ATR)
The average true range is a technical chart indicator that was created by J. Welles Wilder Jr. to measure price volatility. ATR was originally developed for the commodity market, but it can be applied to any other financial market, including stocks, exchange-traded funds, forex, bonds, and futures.
Since the indicator makes use of actual price data that have been printed in the past for its calculation, it measures the historical volatility of the market in question. It does this by decomposing the entire range of an asset price for a period. The indicator calculates what the author called “true range” and then creates a 14-day exponential moving average (EMA) of that true range to get the average true range. A high ATR indicates large trading ranges and, therefore, an increase in volatility, while a low ATR implies a decrease in volatility.
What is the difference between historical volatility and implied volatility?
Implied volatility, unlike historical volatility, measures the market’s expectations of price fluctuations. It is estimated from the price of an option, so it is not based on the past performance of the underlying asset itself. By estimating significant imbalances in demand and supply of options, implied volatility represents the anticipation of changes in the underlying assets over a specific period of time.
There’s a strong correlation between these anticipations and the options premium, whether there’s a price rise when either supply or demand is evident or reducing in periods of equilibrium. Implied volatility metrics are driven by the levels of supply and demand which can be affected by numerous factors such as market events, news related directly to a single company, etc. Implied volatility is an important metric for options traders. It gives traders the probability of whether there will be a volatile market going forward.
Historical volatility, on the other hand, estimates past price fluctuations over a predetermined period of time. It is mostly used by retail traders but not commonly used by sophisticated institutional traders. A rise in historical volatility indicates that the price movement of the security was more than normal. It shows what happened in the past, which may not be indicative of what will happen in the future.
How do you interpret historical volatility?
Historical volatility shows the extent to which the price has been diverging from its average over the given period. Hence, increased price fluctuation is a sign of higher historical volatility. It is important to keep in mind that the historical volatility does not indicate the price direction but rather how unstable the price was.
Volatility is generally a measure of the riskiness of an investment. Low volatility implies reduced uncertainty and risk, while high volatility is an indication of increased uncertainty and risk. But what is considered high volatility? Well, if the price is fluctuating rapidly, hitting new highs and lows very fast, the market may be considered highly volatile. The HV in such a market may be outside 2 standard deviations. Conversely, if the price is stable for a period of time, the HV may be within 2, or even 1, standard deviations, and that market will be said to have low volatility.
Whether volatility is good or bad depends on the trader and their trading approach. For short-term traders, increased volatility may be necessary to make huge profits, but it also increases losses. Applying proper risk management and discipline is crucial. For long-term trading, trend, rather than volatility, is very crucial to making profits.
What is historical volatility ratio?
The historical volatility ratio shows the relationship between short-term and long-term average historical volatility. It is the percentage of short-term to long-term average historical volatility. Usually, a decline in the market’s short-term historical volatility below a certain percentage of its long-term volatility may indicate an imminent explosive move in the market.
How do you trade historical volatility?
HV and other related indicators, such as Bollinger Bands and ATR, can be used conveniently to estimate the volatility in the market when trading. When HV is rising or is higher than average, it means that the price is moving up and down more frequently than normal. This is an indication of uncertainty in the asset and a sign of a potential shift in the current trend. In this case, it may be safer to stay out of the market until volatility reduces.
Keeping an eye on historical volatility when you are trading will help you adjust your trading strategy according to the volatility. High volatility in the price of an asset usually means it is risky. When you are trading such a market, you may have to use wider stop loss and take profit levels, as well as have sufficient margin in your account to avoid a margin call.
In addition to this, HV can be used in a trending market. It measures the deviation of price from the average. In the case of low volatility in a trending market, it means that price is not changing frequently, but rather is changing gradually over a period of time. A long-term trading approach would be best in such a situation, as the price gradually moves in the trend direction without too much gyration.
HV indicators can also be very useful to contrarian and mean-reversion traders. When the price makes exaggerated moves, moving outside 2 standard deviations on either side of the mean, it could be an indication to expect a reversion back to the mean, which might be a signal to trade the reversion move.
Historical volatility is a statistical measure of price distribution around the mean as it advances in any direction. It is based on past price movements and measures the extent to which price has been deviating from its average over a given period. Historical volatility is normally calculated as a standard deviation, but there are other indicators, such as Bollinger Bands and ATR, which can give you an idea of the volatility in the market.
Volatility is used to measure the riskiness of an investment. Increased volatility indicates an increase in risk and uncertainty; whereas decreased volatility indicates lower risk and uncertainty. While past volatility is not indicative of future volatility, using historical volatility can help you optimize your trading strategy to suit the usual conditions in a particular market.