How to Calculate Volatility

There are two main ways to calculate volatility—historical volatility and implied volatility. Let's take a look at both.

Volatility is a measure of the amount by which something fluctuates. It can be used to describe the price volatility of stocks, exchange rates, and even interest rates. Volatility in investments means that prices are not stable over time; they experience large changes between periods of high trading activity. This creates risk for investors because it becomes difficult to know how much money will actually be gained or lost on an investment.

What is volatility?

The simplest definition is that volatility is how much prices change over a given period of time. It tells us something about the magnitude and speed at which price changes occur on average for those periods of time; if volatilities are high, then they typically have larger swings to their lows or highs (or both) than when volatilities are low.

What are the main ways to calculate volatility?

There are two main ways to calculate volatility—Historical volatility and implied volatility. The first is the most commonly used, while the second one takes into account market expectations of future price changes in order to predict how much a stock will fluctuate over time.

Historical volatility

Historical volatility measures past fluctuations that have already occurred by quantifying the daily returns of the asset. In order to calculate historical volatility, the average of all readings must be determined.

To do this you need to take the standard deviation—a measure of how much a set of data is spread out from its mean or average value—of each day’s return and divide by the square root of 252 (the number of trading days). This number is given as a percentage.

Implied volatility

Implied volatility is just what it sounds like—the volatility that is implied by the market prices of options. Also known as projected volatility, it's a significant metric for traders. Implied volatility allows traders to trade options to hedge against future potential changes in volatility.

Unlike historical volatility, implied volatility is measured from the price of the option and signifies the volatility for the future. Implied volatility allows traders to hedge against potential changes in market prices by trading options. Unlike historical volatilities, which are measured from past data points (such as stock price changes), implied volatilities signify the expected future values of that same variable—in this case, volatility. Implied volatilities can be calculated using statistical models such as Black-Scholes. Another way to calculate them would be based on observed cost of hedging (options) through variance swap transactions.

How do I calculate volatility

Because most people don't just hold a single stock option, you may be wondering how to calculate volatility. Volatility is calculated by taking the standard deviation of returns.

- Standard Deviation = (the average amount a stock has fluctuated) - (the lowest and highest values during that period).

- To calculate volatility, find the average return for each month in your portfolio, then divide it by 12 to get an annualized number.

A financial advisor can help you understand volatility risk and what it means for your portfolio

Calculating volatility can be tricky and many find themselves seeking out a financial advisor to manage their portfolio. An investment manager will be an expert on stock options and understand what volatility is and how to calculate it. Unless you’re a financial professional, it’s best to seek out a fiduciary advisor to help you make the best choices for your portfolio.

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