A Must Known Tools for Volatility Trades!

We measure how expensive or cheap options are using a parameter called implied volatility, or IV for short. The term implied volatility comes from the fact that options imply the volatility of their underlying, just by their price. A computer model starts with the actual market price of an option, and measures IV by working the option fair value model backward, solving for volatility (normally an input) as if it were the unknown. 

Again, high IV is synonymous with expensive options; low IV is synonymous with cheap options. It can be useful to plot an asset’s IV over a period of years to see the extent of its highs and lows, as well as what constitutes a normal, or average, level. We measure how much the price of an asset bounces around using a parameter called statistical/historical volatility, or SV/HV for short. There are several different computer models for measuring SV/HV. All of them seek to quantify the extent, or magnitude, of the asset’s price swings on a percentage basis, and use varying periods of the asset’s recent price history (for example, 10, 20, or 30 days). SV can also be plotted, so that the investor can see the periods of relative price activity and inactivity over time.

It is customary to state volatility levels as percentages. Don’t let this confuse you. Volatility is just a number. For example, if the number resulting from calculating HV or IV is 0.27, you would commonly see it expressed as 27%.

What does this number relate to in the real world? Truthfully, volatility does not relate to anything tangible. It is just a number, and it only relates to other volatility numbers. However, I’ll give you something to hang your hat on that is roughly correct. Note that volatility is the percentage standard deviation of price changes. Therefore, as an example, when a stock is 100 and its volatility is 27%, this would indicate that in the coming year this stock’s price should be in a range from 73 (100 × (1 – 0.27)) to 136 (100/(1 – 0.27)) roughly 68% of the time. (From statistics, a standard deviation encompasses 68% of the data samples.)

Many sophisticated options traders go beyond just keeping an eye on volatility, choosing to focus on volatility as the main aspect of their trading. How do they do this, and why? The essence of volatility-based trading, is buying options when they are cheap and selling options when they are dear. The reason it’s called volatility-based trading comes from the way we measure cheapness or dearness—using implied volatility, or IV for short. 

Actually, there are two ways of judging the cheapness or dearness of options. The first is simply by comparing current IV with past levels of IV on the same underlying asset. The second is by comparing current implied volatility with the volatility of the underlying itself. Both approaches are important and come into play in all Volatility-trading decisions. The most attractive opportunities are when options are cheap or dear by both measures. 

The Volatility-trader typically uses puts and calls in combination, selecting the most appropriate strikes, durations, and quantities to construct a position that is said to be delta-neutral. A delta-neutral position has nearly zero exposure to small price changes in the underlying. Sometimes the trader has a directional opinion and deliberately biases his position in favour of the expected underlying trend. However, more often the Volatility-trader is focused on making money just from volatility and is not interested in trying to make money from underlying price changes.

Once a position is on, it may need adjusting at times to re-establish the appropriate delta. These adjustments can be costly in terms of transaction costs and should be minimized, but not to the point where you expose yourself to too much delta risk. Once volatility returns to a more normal, average level, the position can be closed. If not many adjustments were required in the meantime, the trader should see a profit.

Since options are so sensitive to volatility, trading options on the basis of volatility can be lucrative. Occasionally, options become way too expensive or way too cheap. In these situations, the Volatility trader has a considerable edge. The options trader can always count on volatility returning to normal levels after going to an extreme. This principle is called the mean reversion tendency of volatility, and it is the foundation of volatility-based trading.

Happy Trading!!!

Cheers.