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"In real estate, they say that the three most important things are location, location, and location. In options, the three most important things are volatility, volatility, and volatility. Often neglected by option rookies, volatility is the cornerstone of an option professional’s trading strategy.In its simplest form, expressed as the annualized percentage of the standard deviation, volatility measures how far a contract can be expected to swing from a mean price. A contract trading at 50 would have a volatility of 10% if it traded between 45 and 55 over a given period of time.
Historical volatility is just that: the volatility calculated (using closing prices) over a given period – 20 days, 20 weeks, one year, etc. Implied volatility is the volatility using current market prices. For example, using four primary option pricing inputs – futures price, settlement price, time until expiration and volatility – would result in a theoretical price.
By plugging in the current option price in place of the theoretical price and working backward, it would be possible to determine the volatility the current market is implying. (It is not mathematically possible to work backward and solve for implied volatility using an equation like the Black-Scholes model, but an approximation can be derived.)..."
Revisit the Trader's Toolbox Post: "Learning Options Part 4 of 4 " here.
