Profit with Implied Volatility (Part VII)

To be consistently profitable trading options, you must understand implied volatility (IV).  This is the seventh and final post in my “IV Primer.”  I hope the six previous posts on the subject have given you a solid foundation for understanding.  Today, I’m going to discuss three other types of volatility for you to understand alongside implied.

Future volatility describes the price movement of an underlying over some time period in the future.

Historical volatility describes the price movement of an underlying in the past.  For those of you familiar with statistics, this calculation is best done using a sample variance of continuously compounded returns as described here:  http://www.investopedia.com/articles/06/historicalvolatility.asp#axzz1sIuSWBYy.

Forecast volatility is a guess about what the future price volatility of an underlying asset will be.

IV is the market’s forecast of future volatility as reflected by the supply/demand for individual options.  An option’s price is determined by whether it is a put or call, the underlying asset price, the strike price, the time to expiration, the dividend, the interest rate, and the IV.  Given the option price and six out of seven variables, we can algebraically solve for IV.  In addition to the multiple ways this IV Primer has offered to interpret IV, now you know the mathematical “nuts and bolts” of how it is actually calculated.