Should HV and IV Be the Same?
Most option positions have exposure to volatility in two ways. First, the
profitability of the position is usually somewhat dependent on movement
(or lack of movement) of the underlying security. This is exposure to HV.
Second, profitability can be affected by changes in supply and demand for
the options. This is exposure to IV. In general, a long option position
benefits when volatility—both historical and implied—increases. A short
option position benefits when volatility—historical and implied—decreases.
That said, buying options is buying volatility and selling options is selling
volatility.
The Relationship of HV and IV
It’s intuitive that there should exist a direct relationship between the HV and
IV. Empirically, this is often the case. Supply and demand for options, based
on the market’s expectations for a security’s volatility, determines IV.
It is easy to see why IV and HV often act in tandem. But, although HV
and IV are related, they are not identical. There are times when IV and HV
move in opposite directions. This is not so illogical, if one considers the key
difference between the two: HV is calculated from past stock price
movements; it is what has happened. IV is ultimately derived from the
market’s expectation for future volatility.
If a stock typically has an HV of 30 percent and nothing is expected to
change, it can be reasonable to expect that in the future the stock will
continue to trade at a 30 percent HV. By that logic, assuming that nothing is
expected to change, IV should be fairly close to HV. Market conditions do
change, however. These changes are often regular and predictable. Earnings
reports are released once a quarter in many stocks, Federal Open Market
Committee meetings happen regularly, and dates of other special
announcements are often disclosed to the public in advance. Although the
outcome of these events cannot be predicted, when they will occur often
can be. It is around these widely anticipated events that HV-IV divergences
often occur.