Implied volatility is calculated from the option prices of a stock or stock index. Historical volatility describes how much a stock price has varied in the past, and implied volatility is a measurement of how much option traders believe the stock price will change in the future. Option traders use the level of volatility to determine whether it is better to buy or sell option contracts. For stock traders, changes in the level of volatility provide indicators of the future direction of stock prices.
Find a source for implied volatility information. Your online brokerage account will provide historic and implied volatility figures for any stock with options trading against the share price. Another volatility product is the Chicago Board Options Exchange Volatility Index, commonly called the VIX. The VIX can be easily charted and used to predict turning points in the overall market.
Compare the current level of implied volatility with the historic volatility for an individual stock. For the VIX, compare the current level to the average over the last six months to a year. You want to determine whether the current level of implied volatility is above or below historic levels and the magnitude of the departure from the norm.
Use the implied volatility deviations as signals for future stock price action. High implied volatility is usually a bearish signal, forecasting a pending decline in stock prices. Low volatility occurs when the market or stock prices are in an upward or bullish trend.
Tips & Warnings
- Implied volatility is a trend indicator that reacts quickly to changing investor sentiment. To be a useful indicator, the changes in volatility must be closely monitored. Traders should use a combination of different indicators to obtain more accurate trading signals. Trading should not rely on just one indicator, such as implied volatility. Maximum predictive ability occurs when the implied volatility is at the extremes of its range.
- No market indicator is correct 100 percent of the time. Traders using implied volatility should practice with the indicator and understand the risks and limitations of using implied volatility for trading signals.
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