Lately I have been fielding a large number of questions about historical volatility, implied volatility and a variety of related subjects. For this reason, it seems like a good time to kick off what I envision as a series of educational posts on the subject.
First I would like to start out with my own definition of volatility and then throw out some thought starters.
Definition: Volatility is a measure of the degree of change in the price of a security
There are a number of ways to think about changes in the price of a security. For instance, changes in price may be described in terms of:
- magnitude (amplitude) – how far?
- frequency – how often?
- duration – how long?
- trend – unidirectional or choppy?
- direction – up or down?
In terms of measurement, common ways to measure price changes include:
- close to close
- open to close (intra-bar; excludes gaps)
- bar to bar maximum (e.g. Average True Range)
Of course each investor has their preferred unit of time, with each bar representing a minute, five minutes, one day or whatever.
By convention, most investors think of volatility in terms of changes in price, but I submit that volatility be measured in the following units:
- percentage (of price)
- standard deviations
Looking back at the definition, I sometimes like to think of volatility more broadly than I have formally defined it. Consider that volatility can be defined in terms of:
- trend (degree of trending vs. choppiness)
Finally, consider that once measured, volatility can be compared to a number of possible benchmarks. These include:
- external aggregate (broad index)
- relative to peers (sector index, sector ETF, other representative ETF)
- relative to self (including historical volatility and prior implied volatility levels)
I will touch upon all these subjects and more in the coming days and weeks.