Volatility

Volatility is one of the most important variables in options trading. It significantly impacts an option’s premium and contributes heavily to an option’s extrinsic value. Volatility can be defined as a measurement of the amount an underlying instrument is expected to fluctuate in a given period of time. In basic terms, volatility is the speed of change in the market.

Volatility is crucial in the strategy selection process and every options trader needs to be well versed on the types of trades that work best for particular volatility levels. A successful options trader is much like a golfer knowing which club to use or the fisherman who needs to be able to choose the best lure. An options trader should always know the strategy or types of strategies that are best for the current volatility environment.

When the market is volatile, option premiums will be inflated and even if you are right on market direction, as soon as volatility drops, the price of the option will drop. You could be right in market direction and still lose because your option premium goes nowhere or worse, loses value.

Bottom line: learning to check volatility before placing a trade will increase your chances of making a profit. Knowing volatility can also help define which strategy can be best used to make money in a specific market as well as which strategies to avoid. As a general rule, traders look at buying strategies during periods of low volatility and look for selling strategies during periods of high volatility.

Types of Volatility

There are two types of volatility: statistical and implied.

Statistical Volatility

Statistical volatility (also known as historical volatility) represents the standard deviation of a stock’s price changes from close-to-close of trading going back a specified number of days. To determine if a market is volatile or not, the trader needs to compare current volatility to past levels of statistical volatility. Volatile markets are ones that exhibit current levels of statistical volatility greater than past levels. Non-volatile markets typically are those in which the current statistical volatility is less than past statistical volatility.

Implied Volatility

Implied volatility (IV) is a measure of an underlying stock’s volatility as reflected in the option’s price. In other words, implied volatility is the volatility implied by the option’s actual market price. Implied volatility is calculated using the same basic formula used to calculate the fair-value of an option. The only difference is we substitute the volatility input for the current market price of the option. The resulting output produces the implied volatility of the option.

The best thing about implied volatility is that it’s very cyclical; that is, it tends to move back and forth within a given range. Sometimes it may remain high or low for a while, and at other times it might reach a new high or low. The key to utilising implied volatility is in knowing that when it actually changes direction, it often moves quickly in the new direction. Buying options when the IV is high and subsequently drops can cause some trades to actually end up losing money even when the price of the underlying security moves in your direction. In this case, you can take advantage of this situation by selling option premium, instead of buying options.

Charting both statistical and implied volatility helps option traders to visualise where volatility is relative to the past and relative to each other. Just looking at single volatility figures does not mean much unless you can compare those figures with the past. This kind of analysis gives the trader some very important information about the market and specifically the most appropriate option strategies to employ.

Trading Instrument Factor Matrix.