Online Option Trading: Implied Volatility
We have established from the previous page that there are two measures of volatility, HV and IV, the first is an historic comparison of prices, and the second is a mathematically derived figure based on various mathematic assumptions. So can we use these figures for any meaningful conclusions on the current price of an instrument, and more importantly can we forecast the future likely price movements. Being able to forecast whether volatility will rise or decline will largely determine whether you will be successful as an options trader.
OK, let’s consider the IV of the options first. Changes in volatility have a greater effect on the prices of long term options than on the prices of short term options. In other words, if IV rises an option at a given strike price with four months left until expiry will increase much more in value than one with only one month. Remember that time is a wasting asset and as time erodes faster towards expiry the extrinsic value is falling fast until it becomes zero at expiry. So IV will have more effect on an option price, if there is more time available and hence more likelihood of the option moving into the money. The converse of this is also true, so if IV falls, it will have more of an effect on a long term option than on a short term one.
What does the above mean for us as traders. In simple terms it means that if we want to sell options ( or write calls ) then we obviously want to sell options that have the highest price possible when we sell them – in other words they are overpriced! So in simple terms we should be looking at the following to try to help us decide on our strategy.
So, if we want to write options ( sell ) we want to try to find options where the current Implied Volatility is greater than > the past Implied Volatility – in other words the chart is rising. So if the IV today was 30% and 3 months ago was 15%, it is possible that the options are overpriced, provided that we have some idea where the median is for the IV. Implied volatility is like an elastic band, which when fully wound will be at the extremes, but which will eventually always tend to return to the median value. So if we look at an IV chart and we consider the average or mean IV to be 20%, if the values have fluctuated between 15% and 30% and we are currently looking at this as an IV value of 30% then this would suggest we have a current IV greater than past IV above the mean value and at an extreme, and therefore possibly an overpriced option to sell to an unwitting buyer!! ( it’s a cruel life!)
Now obviously as an option buyer or holder, you would be looking for options that were undervalued or cheap so you would look for current IV which is lower than past IV as this would suggest a possible rise in IV causing a rise in option price in the future.
In summary, traders who buy or sell options without any regard to the current levels of implied volatility or the effect that a significant change can have on their positions are like pilots flying in cloud with no instruments – you are bound to crash sooner or later!
Online Option Trading: Historic Volatility
Now with HV we are measuring the volatility of the stock of share compared with its price performance over the last price period. Historic volatility defines the state of the market or instrument and comparing current HV with past HV will indicate whether the stock is in a high volatility or low volatility phase, which will therefore dictate possible trades when combined with the analysis of the IV above.
Now clearly the HV of the asset should give us a guide as to where volatility on the underlying asset is likely to be going in the period of the trade. Clearly if HV is falling or in a downward trend then the volatility of the asset is falling, and if the HV is rising then the volatility of the asset is also rising. So therefore we should be looking for the following to try to help us in selecting our underlying assets.
So if we are looking for a non volatile asset, then clearly we need to look for a chart where the HV current is less then < the HV past. If the HV is high it implies that the stock is very volatile. Some stocks have an HV of 70% and above – which is extremely volatile.
Online Option Trading: HV & IV Together
In the above sections we have looked at how to analyse HV and IV separately, and how to use this to our advantage in trading. The final piece of the jigsaw is to look at them in combination and to see what it all means. Clearly, if there is a gap between the two figures on the chart, then this implies that something is happening. It could be that there is a problem with the maths in calculating the IV ( unlikely! as these are automated and well documented). The HV is unlikely to be incorrect as this is simple mean deviation. So there is a ‘difference of opinion’ between what is happening and what should be happening.
In simple terms we use this information to analyse options and the underlying asset in particular strategies. So for example in using equity options and the covered call writing strategy, we would look for candidates with the biggest difference between Implied Volatility and Historical Volatility. We are therefore looking for candidates where the IV is above the HV, and this gap is a wide as possible. We will look at strategies in a moment, and I do have some sites dedicated to these as they are a subject in themselves.
Now one final point before we move on which I do not propose to cover here in detail as it is a topic in it’s own right, but combining volatility with option volume can also be a powerful indicator. Sudden changes in call or put options when combined with sudden moves in volatility can signal extreme market activity and a possible change in market sentiment. When I first started trading, one of the first markets was index futures and I had two screens, one for the cash market index, and one for the futures market index. By watching the volume in the futures market one could forecast moves in the cash market. So with options it is much the same – by watching the option volume and combining it with volatility changes we can forecast possible changes in trading sentiment in the market. This will be covered in more detail on a future site.
Now that we have a good understanding of options and all the terms, how do we put this knowledge to use and start trading option contracts online – let’s have a look at the possible strategies available and remember I am a very conservative low risk trader.