Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

To be successful as an option trader over the long term, it is essential to fully understand the concept of volatility to put the odds in the trader’s favor when developing option strategies. There are two types of volatility: historical and implied. Historical volatility gauges price movement in terns of past performance and implied volatility is a measurement of volatility that is already a part of an option’s price.

Typically, the higher an underlying stock’s volatility, the greater the level of implied volatility. In other words, an underlying stock that shows a great deal of volatility will command a higher option premium than an underlying stock with low volatility. To illustrate this relationship consider if a trader purchases a call option on an underlying stock with a strike price of 40 and an expiration in December during the month of October. If the stock has been trading between $30 and $35 during the past seven weeks the probability of the option increasing above $40 by December are relatively small. Based on volatility, the December 40 call option will not possess much value.

However, assume the stock has been trading between $30 and $60 during the past seven weeks and has been known to rise as much as $10 in a single trading session. In this particular case, the stock has shown relatively high volatility and therefore the stock has a better chance of rising above $40 by December. As a result, a December 40 call option will have better odds of being in-the-money and thus will have a higher premium as the stock is exhibiting higher levels of volatility.

Veteran option strategists certainly understand that stocks with higher volatility have a greater chance of being in-the-money at expiration than low-volatility stocks. Typically, a stock with higher volatility will have more expensive option premiums than a low-volatility stock. Mathematically, the difference in premiums between the two stocks translates to a difference in implied volatility, which is computed using an option-pricing model like Black-Scholes. Implied volatility is discussed in percentages with low volatility stocks usually less than 20 percent and some extremely volatile stocks registering triple-digit implied volatility percentages.

Option strategists often attempt to measure whether the implied volatility of an options contract is appropriate. For instance, if the implied volatility is too high given the underlying stock’s future volatility, the options may indeed be overpriced and worth selling. However, if the implied volatility is too low given the forecast for the underlying stock, the option premiums may be too low or cheap and worth purchasing. The way option strategists determine whether implied volatility is high or low at any moment in time is to compare it to its past levels.

Statistical or historical volatility also can provide a gauge to determine whether an options contract is cheap or expensive. Since statistical volatility is computed as the annualized standard deviation of past prices over a period of time it is considered a measure of historical volatility because it looks at past prices. Just like implied volatility, it is discussed in terms of percentages.

Finally, option strategists like to compare statistical volatility and implied volatility as a way to measure the appropriateness of current option premiums. If implied volatility is significantly higher than the statistical volatility, the options are considered to be expensive. When implied volatility is low relative to statistical volatility, the options are considered cheap. Effective options strategists are constantly trying to take advantage of large differences between historical and implied volatility (buy low IV and sell high IV). As an options trader, a clear understanding of how volatility is used definitely puts the odds for success in your favor when trading options.     

Happy trading.

Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
Visit Jeff’s Forum

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jeff Neal, Optionetics.com

• July 24, 2008
  Market Insight: Gardner Denver Profiting from Expanding Operating Margins
• July 23, 2008
  Outside the Box: The Benefits of a Systems Trading Approach
• July 22, 2008
  Tech World: Comtech Telecom Showing Stellar Return on Equity
• July 17, 2008
  Market Insight: Wind River Systems Riding Good Earnings Momentum
• July 16, 2008
  Outside the Box: Parts of Eastern Europe Emerging as Big Growth Markets