A PROJECT REPORT ON

STUDY OF IMPLIED VOLATILITY AND HISTORICAL VOLATILITY

SUBMITTED BY

CHANDAN KAILASH KOKANE

ROLL NO - 1009

PGDM – FINANCE

SUB – SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

BATCH 2017-2019

TO

ALL INDIA COUNCIL FOR TECHNICAL EDUCATION

FOR THE DEGREE OF

A POST GRADUATE DIPLOMA IN MANAGEMENT

UNDER THE GUIDANCE OF

Prof. Vasumathy Hariharan

Sir M Visvesvaraya Institute of Management Studies & Research

WADALA (WEST), MUMBAI – 400 031

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 TABLE OF CONTENTS
SR.No. Particulars Page
No.
I Introduction 3
II Volatility 4

III Implied Volatility 5

 Example TO
 Implied Volatility and Probabilities
12
 Visualizing Expected Stock Price Ranges
 Calculating Stock’s Expected Move for Any Time Frame

IV Historical Volatility 13

 How to Calculate Historical Volatility

TO
 Part 1 – Calculating Stock Returns
 Part 2 – Calculating Stock Volatility
18

V Difference Between Implied Volatility and Historical Volatility 19

&

20
VIII Conclusion 21

IX Bibliography 22

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 INTRODUCTION

This study is all about Volatility and it covers the topics like what is volatility, types of volatility

(Implied and Historical Volatility) and difference between Implied Volatility and Historical

Volatility.

Volatility is important from the traders’ point of view as they would come to know that how much

the stock’s price is deviating. There are two types of Volatility - Implied Volatility and Historical

Volatility.

Implied Volatility tells us about what will be the future stock’s price (future volatility) and

Historical Volatility tells us about what has happened in the past and how volatile that stock has

been before in the past?

This study will help you to calculate the historical volatility and will also help you to identify the

future stock's price.

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 VOLATILITY

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most
cases, the higher the volatility, the riskier the security. Volatility can either be measured by using the
standard deviation or variance between returns from that same security or market index. In the securities
markets, volatility is often associated with big swings in either direction. For example, when the stock
market rises and falls more than one percent over a sustained period of time, it is called a "volatile" market.

Market volatility can be seen through the VIX or Volatility Index. The VIX was created by the Chicago
Board Options Exchange as a measure to gauge the 30-day expected volatility of the U.S. stock market
derived from real-time quote prices of S&P 500 call and put options. It is effectively a gauge of future bets
investors and traders are making on the direction of the markets or individual securities. A high reading on
the VIX implies a risky market.

A variable in option pricing formulas showing the extent to which the return of the underlying asset will
fluctuate between now and the option's expiration. Volatility, as expressed as a percentage coefficient
within option-pricing formulas, arises from daily trading activities. How volatility is measured will affect
the value of the coefficient used.

Volatility is important from the traders’ point of view as they would come to know that how much the
stock’s price is deviating. There are two types of Volatility –
1. Implied volatility
2. Actual Volatility

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 IMPLIED VOLATILITY (IV)

- It tells us about what will be the future stock’s price (future volatility).
- It is calculated annually. We cannot calculate on monthly basis or weekly basis.
- It is used to calculate probability. This probability tells you that the stock price can go up to certain
percentage. It can go up or down. It does not predict the direction in which price will go.
- For ex. If IV is 10%, then we can say that stock’s price can go up or down by 10%.
- If IV is high then option premium will also be high. That means stock’s price could swing very
high, very low or both and vice versa.
- When IV is high, traders sell the “put option” and when IV is low, traders buy the “call option”.

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Example

Consider the following stocks and their respective option prices (options with 37 days to expiration):

Stock 105 Call Price 100 Put Price Implied Volatility

PEP ($102.00) $0.80 $1.17 16.41%

UNP ($103.60) $2.72 $1.92 30.94%

As we can see, both stocks are nearly the same price. However, the same options on each stock have
different prices. In the case of UNP, the call and put prices are much higher than PEP's options, which
translates to an implied volatility that is higher than PEP. So, instead of looking at option prices all day
long, options traders use implied volatility to quickly compare the expected price movements (and
therefore, the option prices) of various stocks.

When market participants trade options, they typically do it for one of two reasons:


To speculate on movements in the stock price or implied volatility


To hedge the risk of an existing position against changes in the stock price or implied volatility

Now, if market participants are willing to pay a high price for options, then that implies they are expecting
significant movements in the stock price or implied volatility. Conversely, if market participants aren't
willing to pay much for options, then that implies the market is not expecting significant stock price
movements. Since implied volatility represents the overall level of a stock's option prices, implied
volatility is just a way to describe the size of the market's expectations for stock price movements.

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Implied Volatility and Probabilities

As mentioned before, implied volatility represents the expected range for a stock's price over a one year
period, based on the current prices of options. More specifically, implied volatility represents the one
standard deviation expected price range. In statistics, a one standard deviation range accounts for
approximately 68% of outcomes. To calculate the one standard deviation expected range for a stock's
price after one year, the following formula can be applied:

Let's use this formula to calculate the expected ranges for a few different stocks:

September 28th, 2016

Ticker Stock Price IV Expected Stock Price in One Year

NFLX $97.50 44% Between $54.60 and $140.40

GPRO $16.50 84% Between $2.64 and $30.36

KO $42.25 18% Between $34.65 and $49.85

Clearly, stocks that have higher IV (higher option prices relative to the stock price and time to expiration)
are expected to have much more significant price swings, and vice versa. As a result, higher IV stocks are
perceived to be much riskier (and potentially more rewarding).

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Visualizing Expected Stock Price Ranges –
To demonstrate what an expected range looks like, consider a stock that's trading for $100 with an IV of
25%:

Based on this graphic, we can see that there's an implied 68% probability that this stock trades between $75
and $125 in a year's time. Now, this doesn't mean that the stock won't trade beyond $125 or below $75, but
it does show that the market is pricing in a low probability of such movements.

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To take things a step further, multiplying the expected range by two will give us the two standard deviation
range:

As you can see, a two standard deviation range encompasses 95% of the expected outcomes. Inversely, this
suggests there's only a 5% chance that the stock is trading below $50 or above $150 in a year. If we go one
step further and multiply the expected range by three, we get a three standard deviation range. In statistics,
three standard deviations encompasses 99.7% of the expected outcomes. So, it is very rare for a stock to
experience a three standard deviation move. But, it can (and does) happen!

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Next, we'll visualize the difference between two stocks with different implied volatilities.
Expected Ranges Compared in High and Low Implied Volatility –
To compare two stocks trading at different implied volatilities, we'll look at two hypothetical stocks trading
for $100. Let's say one stock has an IV of 10%, and the other stock has an IV of 25%. In the following
visual, compare each stock's implied probability distribution:

What this visual demonstrates is that low IV stocks are not expected to experience large movements,
whereas high IV stocks are expected to experience much larger price fluctuations. More specifically, the
implied probability of the 10% IV stock trading below $70 or above $130 is virtually zero. However, the
25% IV stock has a much higher implied probability of trading below $70 or above $130.

If we examined out-of-the-money options with the same strike price on each stock, we would find that the
25% IV stock's options are more expensive than the options on the 10% IV stock. For example, the 70 put
or 130 call would be nearly worthless on the 10% IV stock because the implied probability of the stock

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trading to those strike prices is almost 0%. However, if we looked at the 70 put or 130 call on the 25% IV
stock, we'd find that the options have some value because the stock price has a much wider range of
expected prices compared to the 10% IV stock.

Calculating Stock’s Expected Move for Any Time Frame –

For one year expected moves, simply multiplying the stock price by implied volatility will do. However,
for shorter time frames, the expected range calculation must be adjusted. Here is the formula for
calculating a stock's one standard deviation move for any time period:

For example, on a $250 stock with 15% implied volatility, the 30-day one standard deviation move would
be:

If we wanted a one-day calculation, we can adjust the formula accordingly:

Pretty cool stuff! One thing to note about using this formula is that you should use the implied volatility
of the expiration cycle closest to your target time period. For example, if you're calculating a 5-day
expected move, use the IV of a near-term cycle with close to 5 days to expiration. If you're calculating a
180-day expected move, use the IV of a cycle with close to 180 days to expiration.

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Why? Because you want to use the implied volatility of the options that match your target time frame.
Using a different IV number may result in a significantly higher or lower expected move.

Checklist

In summary, here are the key concepts that you've learned about implied volatility:

 Derived from a stock's option prices, implied volatility is just a way to measure the market's expectatio

ns for future stock price movements.

 In terms of probabilities, implied volatility represents a one standard deviation move, which encompa

sses about 68% of the expected future stock prices.

 To calculate the one standard deviation move for a stock over any time period, the following formula can b

e used:

 In terms of risk, stocks with higher implied volatility are perceived to be riskier (and potentially more r

ewarding), as their future price swings are expected to be more significant than low implied volatility stock
s.

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 HISTORICAL VOLATILITY

Is also known as Historiacal volatility as it tells us about what has happened in the past. How
volatile that stock has been before in the past? It tells us about the movement of stock’s price for
the particular period in the past and it is expressed in percentage.

For ex. Reliance was 10% volatile in the past 30 days and HDFC was 15% volatile in the past 30
days. That means HDFC was more volatile than Reliance and therefor HDFC is more riskier than
Reliance.

Historical volatility (HV) is a backward-looking metric that measures how much movement a stock
has experienced over a set time frame. While there are several different methods by which HV can
be calculated, it's most common to take the standard deviation of the difference between the stock's
daily price changes compared to the mean value of the stock during that same lookback period.

It's worth noting that historical volatility is based on changes in the stock's price from one day's
close to the next, and so dramatic intraday swings that fade by the close are not included in this
metric.

In options trading, HV is used as an approximate guide for how much volatility can be expected
from the stock going forward. Specifically, traders often look at a stock's HV to determine whether
or not options are pricing in a "fair" amount of future volatility. Of course, since this is inherently
an apples-to-oranges comparison, historical volatility is not always an accurate predictor of implied
(or forward-looking) volatility.

When comparing historical volatility to implied volatility, or IV, remember to measure comparable
periods of time. For example, if you're gauging IV on an option with two months until expiration,
the appropriate comparison would be to a two-month HV reading. Generally speaking, one calendar
month includes an average of about 21 trading days.

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An annualized one standard deviation of stock prices that measures how much past stock prices deviated
from their average over a period of time.

How this indicator works

 Historical Volatility does not measure direction; it measures how much the securities price is
deviating from its average.
 When a security’s Historical Volatility is rising, or higher than normal, it means prices are moving
up and down farther/more quickly than usual and is an indication that something is expected to
change, or has already changed, regarding the underlying security (i.e. uncertainty). You may want
to research/monitor the security more closely.
 When a security’s Historical Volatility is falling, things are returning back to normal (i.e. uncertainty
has been removed).

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 How to Calculate Historical Volatility –

Stock volatility is just a numerical indication of how variable the price of a specific stock is.
However, stock volatility is often misunderstood. Some think it refers to risk involved in owning a
particular company's stock. Some assume it refers to the uncertainty inherent in owning a stock.
Neither is the case. For investors it represents an important measure of how desirable it is to own a
certain stock, based on the investor's appetite for risk and reward. Here's how to calculate stock
volatility.

Part 1 – Calculating Stock Returns

 Determine a period in which to measure returns. The period is the timeframe in which your stock
price varies. This can be daily, monthly, or even yearly. However, daily periods are most commonly
used.
 Choose a number of periods. The number of periods, n, represents how many periods you will be
measuring within your calculation. If you are calculating daily periods, a common number of
periods is 21, the average number of trading days in a month. A smaller value would not give you
very good results. In fact, the larger the value, the smoother your result becomes.
You can also use 63 periods to represent the number of trading days in three months or 252
periods to represent the average number of trading days in a year.
 Locate closing price information. The prices you will use to calculate volatility are the closing
prices of the stock at the ends of your chosen periods. For example, for daily periods these would
be the closing price on that day. Market data can be found, and in some cases downloaded, from
market-tracking websites like Yahoo! Finance and MarketWatch.
 Calculate returns. The return of a stock in a given period can be defined as the natural log, ln, of
the closing price of a stock at the end of the period divided by the closing price of the stock at the
end of the previous period. In equation form, this is: Rn=ln(Cn/(C(n-1)), where Rn is the return of
a given stock over the period, ln is the natural log function, Cn is the closing price at the end of the
period, and C(n-1) is the closing price at the end of the last period.
On many calculators, the natural log key is simply "ln" and must be pressed after the rest
of the equation has already been calculated.

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 For example, to find the returns when the price closed on one day at $11 and had closed at
$10 the day before, you would set up your equation as Rn=ln($11/$10). This would simplify to
Rn=ln(1.1). Pressing the ln key to solve gives a result of about 0.0953.
The natural log is used to convert the numerical change in value of the stock over the period
to an approximation of the percent change between days.

Part 2 – Calculating Stock Volatility

 Find the mean return. Take all of your calculated returns and add them together. Then, divide by
the number of returns you are using, n, to find the mean return. This represents the average return
over the time period you are measuring. Specifically, the mean, m, is calculated as follows:
m = (R1+R2+...Rn)/ (n).
 For example, imagine that you had 5 periods that had calculated returns of 0.2, -0.1, -0.3,
0.4, and 0.1. You would add these together to get 0.3 then divide by the number of periods,
n, which is 5. Therefore, your mean, m, would be 0.3/5, or 0.06.
 Calculate the deviations from the mean. For every return, Rn, a deviation, Dn, from the mean return,
m, can be found. The equation for finding Dn can be expressed simply as Dn=Rn-m. Complete this
calculation for all returns within the range you are measuring.
 Using the previous example, you would subtract your mean, 0.06, from each of the returns
to get a deviation for each. These would be:
 D1=0.2-0.06, or 0.14
 D2=-0.1-0.06, or -0.16
 D3=-0.3-0.06, or -0.36
 D4=0.4-0.06, or 0.34
 D5=0.1-0.06, or 0.04

 Find the variance. Your next step is to find the mean variance of the returns by summing the squared
individual deviations from the mean of the returns. The equation for finding the variance, S, can be
expressed as: S= (D1^2+D2^2+...Dn^2)/ (n-1). Again, sum the squares of the deviations, Dn, and
divide by the total number of variances minus 1, n-1, to get your mean variance.
 First, square your deviations from the last step. These would be, in order: 0.0196, 0.0256,
0.1296, 0.1156, 0.0016.
 Sum these numbers to get 0.292.

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  Then, divide by n-1, which is 4, to get 0.073. So, S=0.073 in the example.

 Calculate the volatility. The volatility is calculated as the square root of the variance, S. This can
be calculated as V=sqrt(S). This "square root" measures the deviation of a set of returns (perhaps
daily, weekly or monthly returns) from their mean. It is also called the Root Mean Square, or RMS,
of the deviations from the mean return. It is also called the standard deviation of the returns.
 In the example, this would just be the square root of S, which is 0.073. So, V=0.270.
 This number has been rounded to three decimal places. You may choose to keep more
decimals to be more accurate.
 A stock whose price varies wildly (meaning a wide variation in returns) will have a large
volatility compared to a stock whose returns have a small variation.
 By way of comparison, for money in a bank account with a fixed interest rate, every return
equals the mean (i.e., there's no deviation) and the volatility is 0.

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 DIFFERENCE BETWEEN IMPLIED VOLATILITY AND HISTORICAL VOLATILITY

Implied Volatility and Historical Volatility

Historical volatility (HV) is the volatility experienced by the underlying stock, stated in terms of annualized
standard deviation as a percentage of the stock price. Historical volatility is helpful in comparing the
volatility of one stock with that of another stock or to the stock itself over a period of time.

For example, a stock that has a 15 historical volatility is less volatile than a stock with a 25 historical
volatility. Additionally, a stock with a historical volatility of 35 is now more volatile than it was when its
historical volatility was, say, 20.

In contrast to historical volatility, which looks at actual asset prices in the past, implied volatility (IV) looks
ahead.

Implied volatility is often interpreted as the market’s expectation for the future volatility of a stock. Implied
volatility can be derived from the price of an option. Specifically, implied volatility is the expected future
volatility of the stock that is implied by the price of the stock’s options.

For example, the market (collectively) expects a stock that has a 15 implied volatility to be less volatile
than a stock with a 30 implied volatility. The implied volatility of an asset can also be compared with what
it was in the past. If a stock has an implied volatility of 40 compared with a 20 implied volatility, say, a
month ago, the market now considers the stock to be more volatile.

Analysing Volatility

Implied volatility and historical volatility are studied using a volatility chart. A volatility chart tracks the
implied and historical volatility over time in graphical form. It is a helpful visual aid that makes it easy to
compare implied volatility and historical volatility. But volatility charts are often misinterpreted by novice
traders.

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Volatility chart practitioners need to perform three separate analyses. First, they need to compare current
implied volatility with current historical volatility. This helps the trader understand how volatility is being
priced into options in comparison with the stock’s volatility. If the two are disparate, an opportunity might
exist to buy or sell volatility (i.e., options) at a “good” price.

In general, if implied volatility is higher than historical volatility it gives some indication that option prices
may be high. If implied volatility is below historical volatility, this may mean option prices are discounted.

But that is not the end of the story. Traders must also compare implied volatility now with implied volatility
in the past. This helps traders understand whether implied volatility is high or low in relative terms. If
implied volatility is higher than typical, it may be expensive, making it a good a sale; if it is below its
normal level, it may be a good buy.

Lastly, traders need to complete their analysis by comparing historical volatility at this time with what
historical volatility was in the recent past. The historical volatility chart can indicate whether current stock
volatility is more or less than it typically is. If current historical volatility is higher than it was in the past,
the stock is now more volatile than normal.

If current implied volatility doesn’t justify the higher-than-normal historical volatility, the trader can
capitalize on the disparity by buying options priced too cheaply.

Conversely, if historical volatility has fallen below what has been typical in the past, traders need to look
at implied volatility to see if an opportunity to sell exists. If implied volatility is high compared with
historical volatility, it could be a sell signal.

The Art and Science of Implied and Historical Volatility

Analysing implied volatility and historical volatility on volatility charts is both an art and a science. The
basics are discussed here, but there are lots of ways implied and historical volatility can interact.

Each volatility scenario is unique. Understanding both implied and historical volatility combined with a
little experience helps traders use volatility to their advantage and gain edge on each trade.

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 Conclusion

Volatility is an essential component of options trading. Nonetheless, many options

traders do not pay it sufficient attention, and their returns frequently suffer as a result.
When volatility is high, options buyers should be cautious about straight options
buying. Rather, they should typically be looking to sell instead. Low volatility, on
the other hand, generally takes place in quieter markets, and it can mean a better
situation for buyers. Still, there’s no guarantee that the market will move
dramatically at any time soon.

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 Bibliography

 https://www.moneyshow.com/articles/optionsidea-25848/
 https://www.wikihow.com/Calculate-Historical-Stock-Volatility
 https://www.schaeffersresearch.com/education/volatility-basics/what-is-
volatility/historical-volatility
 https://www.investopedia.com/terms/h/historicalvolatility.asp
 https://www.investopedia.com/terms/i/iv.asp
 https://www.investopedia.com/university/optionvolatility/volatility9.asp

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