Volatility and Options Trading

If you want to make money as a trader, you need movement and you need it now. The more the merrier. Most people associate volatility with their high school football coach. Others view it as something to be avoided. And a few-mainly option and commodity traders- see volatility as opportunity.

Volatility is the measure of variance around the mean price. If a stock has low volatility, its band of price movement is limited. On the other hand, a stock with a wide band of price movement is considered volatile. Most investors want to have the value of their investments increase over time. But traders want price to move rapidly and with variation. If a trader can predict the proper direction of movement within a certain time frame, they can make many trades with small profits which will compound over time. Traders want movement and they want it now! To do that, they need investment vehicles with volatility and options can certainly fill the bill.

Types of volatility

There are two types of volatility: implied and historical.

Implied volatility is what the market expects for a stock's price movement. If implied volatility is high, the market expects the stock price movement to be choppy. Of course, low implied volatility suggests smoother stock price movements within a limited price range.

Implied volatility is, indeed, the same as option value. However, implied volatility can be different for different positions on the same stock. Typically, when volatility on a stock is on the rise, the market is focusing on the stock and something out of the ordinary is happening. If a stock is breaking out, and is not accompanied by volatility, the breakout will probably not be sustained. If volatility builds up along with other technical indicators, a break-out can be significant.

Historical volatility measures the stock price changes in the market and translates this into a statistical measure of variance. We won't concern ourselves with the math but the result is presented as an annualized percentage. This percentage provides an idea of how far the stock price can vary from its average price. For instance, if a stock has an average price of $40 with a volatility of 50% this means that price could vary between $20 and $60.

An option price is affected by several components: the strike price, days to expiration, current stock price, dividends paid (within the option period), interest rates and implied volatility. Each stock has many options and each will be different mainly due to implied volatility. In general, out-of-the- money (OTM) options have a higher implied volatility because of more risk than at or in-the-money options. Moreover, puts and calls for the same period usually doesn't have the same implied volatility.

A good option trading strategy using volatility

Covered Call writing is when an owner of the underlying stock sells (writes) an out of the money call. This is a popular strategy and is considered a conservative option trade. According to Ravi Kant Jain in his article "Putting volatility to Work", a trader should start with a mildly bullish stock. If a trader picks a very bullish stock, it could be akin to shooting oneself in the foot as the trader will lose the potential gains of owning the stock unencumbered by having it called away if n option is exercised. Historical volatility is the next thing to consider. If the historical volatility is high, this demonstrates that the stock moves a lot. That's good. This means that the stock has a good chance of moving below the strike price as well as above it. Jain recommends that the best candidate is a stock with the biggest difference between implied (option premium) and historical volatility.