The Volatility Ratio Puts Market Volatility into Historical Perspective
The volatility ratio tells day traders what the implied volatility of a security is relative to the recent historical volatility. This ratio shows whether the security is expected to be more or less volatile right now than it has been in the past, and it’s widely used in option markets.
The first calculation required is implied volatility, which is backed out using the Black-Scholes model, an academic model for valuing options. When you plug in to the model certain variables — time until expiration, interest rates, dividends, stock price, and strike price — the implied volatility is the volatility number that then generates the current option price. (You don’t have to do these calculations yourself because most quotation systems generate implied volatility.)
After you have the implied volatility, you can compare it to the historical volatility of the option, which tells you just how much the price changed over the last 20 or 90 days.
If the implied volatility is greater than the statistical volatility, the market may be overestimating the uncertainty in the prices, and the options may be overvalued. If the implied volatility is much less than the statistical volatility, the market may be underestimating uncertainty, so the options may be undervalued.