What Is Historical Volatility (HV)?
Let me explain historical volatility (HV) to you—it's a statistical measure of the dispersion of returns for a given security or market index over a specific period. You calculate it by finding the average deviation from the average price of a financial instrument in that time frame. The most common method is using standard deviation, though it's not the only way. If the HV value is higher, the security is riskier, but remember, risk goes both ways—bullish and bearish—so it's not always a negative.
Understanding Historical Volatility (HV)
You need to know that historical volatility doesn't specifically measure the likelihood of loss, though you can use it for that purpose. What it really does is show how far a security's price moves away from its mean value. In trending markets, HV measures how far traded prices deviate from a central average or moving average price. This means a strongly trending but smooth market can have low volatility even if prices change dramatically over time—its value doesn't fluctuate wildly day to day but shifts steadily.
I often compare this measure with implied volatility to see if options prices are over- or undervalued. HV also plays a role in all types of risk valuations. Stocks with high historical volatility usually demand a higher risk tolerance from you. And in high volatility markets, you'll need wider stop-loss levels and possibly higher margin requirements. Beyond options pricing, HV serves as an input in other technical studies like Bollinger Bands, where the bands narrow and expand around a central average based on volatility changes measured by standard deviations.
Using Historical Volatility
Volatility gets a bad rap, but you as a trader or investor can actually make higher profits when volatility is higher. Think about it—if a stock or security doesn't move, it has low volatility, but it also has low potential for capital gains. On the flip side, a security with very high volatility can offer tremendous profit potential, but at a huge cost—its loss potential is just as tremendous. You have to time your trades perfectly, and even if your market call is correct, wide price swings could trigger a stop-loss or margin call and lead to losses.
So, volatility levels should ideally be somewhere in the middle, and that middle varies from market to market and even from stock to stock. You can use comparisons among peer securities to figure out what level of volatility is 'normal' for a given context.
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