Of all the factors that go into trading options (and there are a lot of them!), volatility is probably the most under-utilized and least understood by beginning traders.Most traders new to option trading will focus solely on the immediate price of the underlying asset (ie the share price or futures price).They don't take into consideration that volatility values go into calculating the value of the option.However, professional traders will focus much more heavily on the volatility of the underlying asset and make their decisions accordingly.In fact, many professional traders say that volatility trading is like trading in slow motion.How easy does that seem?This article will give a brief introduction to the different types of volatility that a trader will encounter when trader options.Implied Volatility (IV).This is the estimated volatility of a security's price in real time, or as the option trades.The IV values are derived from formulas that measure what the options market expects and tries to predict what the underlying asset's volatility will be over its life.These values tend to fall when the asset is in an uptrend and rise when the market downtrends.Mark Powers, in Starting Out In Futures Trading(McGraw-Hill), describes IV as an "up-to-date reading of how current market participants view what is likely to happen.".Historical volatility (HV).This is also referred to as statistical volatility (SV).This type of volatility is a measurement of the movement of the price of a financial asset over time.It is calculated by figuring out the average deviation from the average price of the asset in the given time period.Standard deviation is the most common way to calculate historical volatility.HV measures how fast prices of the underlying asset have been changing.It is stated as a percentage and summarizes the recent movements in price.HV is always changing and has to be calculated on a daily basis.Because it can be very erratic at times, traders tend smooth out the numbers by using a moving average of the daily numbers.At most times, IV and HV are different in value.If this was a perfect world, they should be fairly close together, as they are supposedly measuring two financial assets that are very closely related to each other (ie the option itself and the underlying asset).However, there will be many times where these values will be quite different, and it is these times that can provide some exciting trading opportunities.This is a concept called "options mispricing" and being able to understand this concept can be of great assistance in your trading decisions!In later articles, I will be looking at how you can use this knowledge of volatility to effectively trade options over longer periods of time with a great degree of accuracy.
Saturday, August 18, 2012
Volatility in Options Trading
Of all the factors that go into trading options (and there are a lot of them!), volatility is probably the most under-utilized and least understood by beginning traders.Most traders new to option trading will focus solely on the immediate price of the underlying asset (ie the share price or futures price).They don't take into consideration that volatility values go into calculating the value of the option.However, professional traders will focus much more heavily on the volatility of the underlying asset and make their decisions accordingly.In fact, many professional traders say that volatility trading is like trading in slow motion.How easy does that seem?This article will give a brief introduction to the different types of volatility that a trader will encounter when trader options.Implied Volatility (IV).This is the estimated volatility of a security's price in real time, or as the option trades.The IV values are derived from formulas that measure what the options market expects and tries to predict what the underlying asset's volatility will be over its life.These values tend to fall when the asset is in an uptrend and rise when the market downtrends.Mark Powers, in Starting Out In Futures Trading(McGraw-Hill), describes IV as an "up-to-date reading of how current market participants view what is likely to happen.".Historical volatility (HV).This is also referred to as statistical volatility (SV).This type of volatility is a measurement of the movement of the price of a financial asset over time.It is calculated by figuring out the average deviation from the average price of the asset in the given time period.Standard deviation is the most common way to calculate historical volatility.HV measures how fast prices of the underlying asset have been changing.It is stated as a percentage and summarizes the recent movements in price.HV is always changing and has to be calculated on a daily basis.Because it can be very erratic at times, traders tend smooth out the numbers by using a moving average of the daily numbers.At most times, IV and HV are different in value.If this was a perfect world, they should be fairly close together, as they are supposedly measuring two financial assets that are very closely related to each other (ie the option itself and the underlying asset).However, there will be many times where these values will be quite different, and it is these times that can provide some exciting trading opportunities.This is a concept called "options mispricing" and being able to understand this concept can be of great assistance in your trading decisions!In later articles, I will be looking at how you can use this knowledge of volatility to effectively trade options over longer periods of time with a great degree of accuracy.
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