Suppose Stock A and Stock B are currently trading at the same price of $100. Why might their calls with the same strike and expiration be priced at different premiums? The answer may be found in the volatility of the underlying stock.

Historical Volatility of a Stock

Volatility measures the amount of fluctuation or price movement in a stock over a given period. A higher volatility means a stock's price tends to fluctuate more over time. A lower volatility means that a stock's price tends to be more stable.

The hypothetical case in the chart below shows the two stocks' historical pricing over 12 months. Even though they both start at $100 and end at $100, Stock B is more volatile than Stock A with significantly more fluctuation in its price over that time.

In practice, traders can use Historical Volatility (HV) to measure how much the stock price is deviating from its average, often expressed as a percentage of the standard deviation of daily returns. HV does not indicate the direction of a stock's movement, as volatility increases with drastic price swings up or down. . Historical volatility is a backward-looking measure. It reflects the volatility of a security's price in the past. As a result, it may not necessarily be a reliable indicator of future price movements.

Implied Volatility on Each Option Contract

Unlike historical volatility, which is calculated from past price changes in the underlying security, Implied Volatility (IV) is derived by starting with the current market price of a stock or option, and putting it through the chosen pricing model backward.

There are a number of methods and models you can use to calculate the Implied volatility of an option, including the Black-Scholes Model. These models use the current market price of the option, as well as certain assumptions about the underlying security, such as its current price, the risk-free interest rate, and the time remaining until the option's expiration date, to derive its implied volatility.

For example, suppose there is an increasing demand for ABC call options in the marketplace, bidding up ABC call option prices. All else being equal, the rising premium will lead to the higher implied volatility of the call option contract.

Because the price of the option contract is a function of supply and demand, IV is assumed to represent the market's consensus on the future volatility of the underlying asset over the option's life. On the options chain page, you can check the real-time implied volatility data (powered by CBOE Hanweck) for every option on an underlying contract.

Implied Volatility on a Specific Symbol

Every contract has its own implied volatility, even different contracts on the same underlying symbol. The factors that influence option prices are weighed differently between different strikes and expirations, IV among them.

Some traders refer to formulas and calculations designed to approximate an overarching IV for all options on a given symbol, although this can be difficult to achieve and incorporates subjective value judgments.

One way of calculating such an overarching IV is by weighing the individual IV values against other criteria. Some assign greater weight to the volume of options traded, or to open interest, while others give the greatest weight to the at-the-money options, as is most common.

A consistent IV metric can help you to make informed investment decisions. For example, when the implied volatility of a security is relatively high, it generally indicates that the market expects the stock price to be volatile. Whether you agree with the market sentiment or not, you may want to adjust your investment strategy accordingly. The knowledge about market attitudes provided by IV can help you do just that.

The implied volatility of a symbol changes over time, depending on market conditions and other factors. It's important to regularly check the implied volatility of a symbol—as it is with any indicator you use to craft your trading strategy—and make any necessary adjustments to your plans.

The Bottom Line

Both historical volatility and implied volatility can be useful indicators for investors and traders. Historical volatility, a backward-looking indicator, can help you understand how the security has behaved in the past, providing helpful context to gauge the regularity of current trends. On the other hand, implied volatility is a forward-looking measure that can help you gauge market sentiment and assess the potential risk of a stock or option.