Volatility Edge - Using volatility to trade

Epic sagas have been published on this subject, each providing for varying levels of expertise.  Most of them, I believe, are some variations of the ‘get rich quickly’ scheme.

Volatility continues to remain mysterious to most of the investors, who unfortunately do not have a complete grasp of what forms a foundational concept underpinning equities and derivatives trading. Known by other names such as Variance or Standard deviation, volatility is simply a measure of risk and as such, this parameter influences the prices of the underlying (stock or options) to a great extent.

Volatility is the rate at which the price of security increases or decreases for a given set of returns. In effect, it shows the range over which, the price of the security may increase or decrease. Volatility is a measure of how rapidly and by how much price the underlying asset moves as well as the reason why option prices fluctuate and act the way they do. Security is deemed to have high volatility if the prices of that security fluctuate rapidly in a short period of time. Likewise, securities that witness a slow fluctuation in prices over a longer period of time, is said to have low volatility.

With the exception of volatility, each of the parameters used in the option pricing formula, namely strike price, underlying price, time to expiry, and interest rates have a precise known value. The only unknown variable is the volatility and accurate investigation of volatility, which is highly valuable for the options trader. Generating positive returns consistently without reliably understanding volatility is almost impossible.

There are two types of volatilities that are of concern to an options trader.

• Statistical or Historical volatility
• Implied volatility

Historical or Statistical volatility is a measure of the fluctuations of the stock price in the past. HV is obtained by calculating the standard deviation of historical daily price changes (i.e daily returns) over a specified period. Meanwhile, Statistical volatility is a measure of the stock price fluctuations in the past. HV is obtained by calculating the standard deviation of historical daily price changes (i.e. daily returns) over a specified period.

Implied Volatility is an estimate (future) of the volatility of the underlying asset. A higher IV reflects a greater fluctuation (in either direction) of the underlying asset price. IV can be calculated by using the BS valuation model and is called implied volatility because it is the volatility implied by the option’s market price. When volatility is calculated by reverse-engineering options market prices, it essentially becomes both a market price for and an expectation of uncertainty.

Long positions should be established only when you believe that the volatility priced into the option contracts is too low.

The reverse is true for short positions. They make sense only when the underlying volatility is too high.

Establishing a long position is tantamount to buying volatility, and short positions involve selling volatility. This is because option positions are often composed of both the long and short components, while the terms ‘net long’ and ‘net short’ generally are more appropriate.