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The Two Faces of Volatility

The Two Faces of Volatility

In Roman mythology the god of beginnings and endings, Janus, is typically portrayed having two heads, each facing in opposite directions. His countenances are displayed in this manner so that he can observe the past as well as the future.  The two types of option volatility, historical volatility and implied volatility, also reflect this dual perspective.



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Historical volatility, also termed statistical volatility by some writers, is a simple mathematical calculation of the demonstrated volatility over various periods of time, hence the name historical volatility. While the precise method of calculation of historical volatility can be argued endlessly, it represents an objective and reproducible measurement that requires only the input of the variable of price movement.

Implied volatility is to be distinguished from the mechanical precision of historical volatility.  Implied volatility is the nexus point at which the raw emotions of the human brain so evident in trading meet the mathematical precision of the historical volatility. Of the three primal forces impacting option price, implied volatility is the only factor subject to cerebration. As a malleable and subjective input factor, it is reflective of both general market sentiment and the subjective evaluation of potential future volatility and direction of the specific underlying. As such, it is a forward-looking evaluation as opposed to historical volatility which is well, historic.

While this distinction may seem arcane and of academic interest only, it is decidedly not. Failure to consider the current position of implied volatility will routinely negatively impact trades and is the most frequent cause of paradoxical behavior of option prices.