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What is Volatility?

What is Volatility?

Volatility is measure of how likely a stock price will change. One method of measuring volatility, Historical volatility , is computed by examining past changes in the underlying stock price. Historical volatility can be computed over different periods of time. The 30 day historical volatility is the measure of volatility using prices for the past thirty days. The 30 day historical volatility measure may be quite different from the 365 day volatility, since a stock which is flat most of the year may have had recent unusual activity. Those measures of volatility can be used to imply the likelihood of future price movement over the next 30 or 365 days, respectively - assuming past volatility can predict future volatility.

Volatility is a significant factor used to compute the price of options. The more likely a stock is to move, the more expensive the option. One method to compute option prices is to take the historical volatility and plug it into an option pricing model to come up with a price for the option.

Implied Volatility

What if the option price is already known? If the price of an option can be computed using the volatility, then the volatility can be implied from the option price. The measure of volatility that is computed using a known option price is the implied volatility. If the option price is high, it indicates a greater likelihood that the stock price will change, implying that the volatility must be high.

Stocks with high volatilities are more likely to move than stocks with low volatilities. The first step to effective stock picking is to assess the likelihood that a stock will move. For a list of stocks with the highest volatilities, visit the Most Volatile Stocks page.

More Than One Volatility

The volatility of a stock can be computed from an option price. But a stock can have many options, and the computation of the volatility may be different for each option. These differences, particularly when examined along with volume and open interest, can reveal which options are most in demand. If calls are more desirable than puts, it indicates that the public sentiment is bullish on the underlying stock. Commonly, demand for calls will outweigh puts or vice-versa, and this skew shows investor bullishness or bearishness. The second step to profitable trading is to assess the likelihood of a stock moving in a particular direction. To see a graphical representation of the variances in option prices, use the Volatility Skew feature.

Putting Volatility to Use

Once a stock that is likely to move has been identified and the likely direction has been determined, an appropriate trade must be selected. To learn about the probabilities of profiting from a trade and picking the best trade, read about our exclusive Trade Finder.

Data Provided by HistoricalOptionData.com
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