Introduction:
The Historic Volatility indicator is used mainly as an option evaluation tool. It does not give trading signals like those given with other technical indicators. What it does do is give the trader an idea of how volatile the market has been for the previous period of time.
Changing the period of time the study observes allows the trader to fine tune options prices. If a market has been extremely volatile for the past 3 months, for example, then near term options should be more expensive. If the market has been calm for an extended period of time longer term options should be reasonable.
Its use in futures is for observation, telling the trader if prices are calming down or becoming more erratic.
Interpretation:
The key to using historic volatility is determining the correct period of time for each market. The market you are looking at may show a history of volatility years ago but may have been relatively calm the last few months. Getting an idea of the markets behavior recently may be of no use to the trader that is looking at distant options and vice versa for the trader looking at near term options.
For the futures trader this tool is useful as a guide for order placement. Seeing that market volatility is changing may indicate that it is time to move stops closer or farther away. If the trader is profitable with the trend and volatility is changing it might be a time to move stops closer to protect profits. If a trader is trading against the trend, they might want to move stops further away to avoid getting bumped out prematurely.
Options traders could use this study to help them purchase profitable options. The basic idea is to buy options when volatility is decreasing to take advantage of a change in that volatility. Any rise in volatility will translate to an increase in option values. Look at options strategies that take advantage of low volatility, such as straddles or ratio spreads. When volatility is high selling options would be better, because any decrease in volatility will translate to a loss of option value. Option strategies that take advantage of a decrease in volatility are strangles and regular short option positions.
Obviously, historic volatility is only one component of option pricing. Any changes in the underlying futures market could negate the changes in option prices due to volatility. For example, if you were to buy a low volatility Put option and prices go higher that option will lose value but not as quickly as a higher volatility option.
For the futures trader the basic concept is to expect market changes during periods of increased volatility. George Soros, the trading legend, said "Short term volatility is greatest at a turn around and diminishes as a trend becomes established."
This indicator is commonly viewed as very mean regressive. What this term means is that the historic volatility indicator tends to return to the opposite end of the spectrum and therefore return to an average. If volatility is great it will eventually cool off and return to that place. If volatility is low it will not stay quiet forever. What this means to traders is that a market that is erratic will sooner or later calm down and a market that is quiet will eventually get loud again.
Example of Historical Velocity in the Indicator Window:
Calculation:
Parameters:
Period (20) - the number of bars, or period, used to calculate the study. You may alter this to use any number greater than 1 for the close. The historical volatility displays in simple percentage values.
Formula:
The calculation for the historical volatility is rather involved. The number of periods per year vary depending on the type of price chart used for the study. The following table lists the number of periods for each type of chart:
