Options Trading Volatility

Volatility can be a fearful thing since it can seem so complicated in its mathematical analysis. Novice traders will often avoid learning about it because it is so intense. Of course, this puts the novice traders at a disadvantage to the experienced trader who can understand it and use it to their advantage. But volatility can be easy to understand!

Volatility is the measure of how much the price will change and how fast it is changing. If the stock fluctuates wildly from day to day over the period of several days, it will be known as having a high volatility rate.

If the prices change slowly, this is important because it gives investors plenty of time to react. If the prices change by just a little amount each time, then there is little profit or loss for the investor. Both of these factors can be important when weighing the overall risk of the investment. The more steady the prices are, the less risk is involved.

There are several different ways to define and measure volatility in the marketplace, however.

The most common statistical concept is something called the “standard deviation.” The calculation for the standard deviation is complicated, but fortunately, the idea behind it is very simple. It will essentially measure how far from the average a certain number deviates. That calculation can be shown in charts plotting a certain time range, like a year.

Implied Volatility, on the other hand, is a variation of that number. You can use a number of factors to help determine this number, including market price, strike price, expiration dates and the interest rate. Why would a trader care about all of these factors?

The Implied Volatility will increase when the market is bearish and it will decrease when the market is bullish.

The deviation from the normal average and the measurement that its movement will likely go in one specific direction becomes the foundation for betting on future movements in the financial markets. In this way, the trader uses volatility for evaluating the trades.

Options are fundamentally based on risk and volatility operates by measuring risk. One of the most common ways to gauge the risk on an investment is through the VIX or Volatility Index. The CBOE (Chicago Board of Exchange) created this to calculate the weighted average of IV. The data that comes around the average from a variety of strike prices for all the calls and puts in the S&P 500.

Traders will use the VIX amount to gauge the market sentiment and overall feeling. As the VIX increases, the market goes down and vice versa.

Volatility implies an uncertain investment or market and trader will be less concerned about a rising stock price than a decreasing stock price. Most of the time, traders will look to gain profits from an increased market price, not a decreased one. The higher the amount of risk involved, the higher the implied volatility and the more expensive the options will become.

If the market is declining in general, puts will become popular since traders will expect the decrease to continue. But if the market is in decline and puts are popular, the price of the put will increase because higher demand will mean higher prices.

         

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