Understanding the Four Measures of Volatility

A Look at Johnson & Johnson and Rackable Systems

For a real world example of historical volatility in action, let's look at Johnson & Johnson (JNJ Quote), a low volatility stock, and Rackable Systems (RACK Quote), a high volatility stock. In the chart below, observe the relative volatilities and the deviations thereof over the course of the recent market meltdown.

Click here for a larger view of the historical volatility chart.

Volatility and Options

Volatility is one of the many important inputs -- along with market price, strike price, interest rates, dividends and time -- in calculating the value of an option. The most popular options pricing model is Black-Scholes. If you desire to torture yourself with how the Black-Scholes options pricing model works, I have provided a link for further reference. When calculating an option price, one merely inputs the volatility as a given for the reference security (underlying security, in options speak) for a period of time to match the remaining days to expiration, along with the other required variables, into the Black-Scholes model, and out pops the option valuation.

Note: To learn more about options, check out the Futures and Options section of TheStreet University's Getting Started index.

Type 2: Implied Volatility

The options market is a bid and offer system in which buyers and sellers come together in an auction environment to actuate price discovery and execute trades. These prices are quoted in dollars and cents. From these prices, knowing all of the other Black-Scholes variables and using the Black-Scholes formula, we can calculate the volatility, which is implicit from a traded price or the bid and offer. This is referred to as the option's implied volatility. Whereas historic volatility is static for a fixed given period of time, please note that implied volatility will vary for a stock based on different options strike prices. This is referred to as the volatility skew.

Johnson & Johnson and Rackable Revisited

For the same two stocks that I examined before for historical volatility, below I have presented implied volatilities. As was the case with historical volatility, the weighted implied volatilities were higher for RACK and lower for JNJ. However, the impact of the market correction was felt more by JNJ than RACK because of the already elevated implied volatility for RACK. Also, observe that the implied volatilities for both JNJ and RACK are higher than the historical volatilities. This is due to the speculative nature of options trading.

Click here for a larger view of the implied volatility chart.