Volatility Smile - Implied Volatility and Historical Volatility

Implied Volatility and Historical Volatility

It is helpful to note that implied volatility is related to historical volatility, but the two are distinct. Historical volatility is a direct measure of the movement of the underlying’s price (realized volatility) over recent history (e.g. a trailing 21-day period). Implied volatility, in contrast, is determined by the market price of the derivative contract itself, and not the underlying. Therefore, different derivative contracts on the same underlying have different implied volatilities as a function of their own supply and demand dynamics. For instance, the IBM call option, struck at $100 and expiring in 6 months, may have an implied volatility of 18%, while the put option struck at $105 and expiring in 1 month may have an implied volatility of 21%. At the same time, the historical volatility for IBM for the previous 21 day period might be 17% (all volatilities are expressed in annualized percentage moves).