Option Trading System
Historic and Implied Volatility: Now, one of the most important parts of online options trading is understanding all about volatility of which there are two, whatever option trading system you use: Implied Volatility and Historic Volatility. The term is used so loosely that if you asked most people for a definition, it would probably be something along the lines of ‘prices moving about wildly’ . In fact you hear the term used in most days in the media where markets are described as ‘volatile’. To understand if markets are volatile or not, we need to compare current statistical levels of volatility with past statistical levels – so to say markets are volatile is meaningless. There are two measures of volatility that we need to understand in order to become good options traders, historical volatility ( HV) , and implied volatility( IV).
Online Option Trading: Historic Volatility (HV)
OK, let’s start with a definition of historic volatility which is as follows :
Historical Volatility is a measure of price movement over time. It uses historical price data to empirically measure the volatility of a market or instrument in the past. The value rendered by a historical volatility study is the standard deviation of candle to candle price differences. The price data periods can be hours, days, weeks or months.
Don’t panic, you don’t have to calculate the HV of an instrument, there are various sites which provide free or subscribed services which will give you this information in a graphical format. The important points to note are twofold. Firstly it is meaningless to say that markets are volatile ( which we hear all the time ) As you will see from the above statement HV is a measure of volatility by comparing today’s price movement with price movement in the past. The measure used is Standard Deviation, and yes there is a formula, but I do not propose to show it here, as it is too much information. Just remember for now that the HV of an instrument is a comparison of how far prices have deviated from the norm today, compared with how far they have deviated in the past. If the HV chart is in a downwards trend then clearly current statistical volatility is lower than past statistical volatility and there fore the instrument is less volatile at present compared with the past. HV on it’s own only gives us a measure of comparison – it tells us little else. In order for it to give us some meaningful data, we need to compare it with another measure which is Implied Volatility (IV).
Online Option Trading: Implied Volatility ( IV)
OK, as with HV above, let’s define what we mean by Implied Volatility:
The Implied Volatility (IV) of a financial instrument is an estimate of the rate of price change of the instrument, and is interpreted from as the markets expectations of future volatility.
The term Implied Volatility comes from how it is derived, as it is calculated from theoretical pricing models which use a variety of mathematical models. Now for options that model would probably be the most common which is the Black-Scholes, whilst for stocks and shares it would probably be calculated using a weighted average from the options quoted on that particular stock. IV is usually calculated by treating the volatility as the unknown in the equation and then using the market prices to solve the equation to find the IV. Enough of the maths lesson!!
All you need to remember from the above is this :
- There are two types of volatility – HV and IV
- These can be applied to options/stocks and other financial instrument
- We use these two measures to identify trading opportunities
The chart chart shown here is that for McDonalds stocks on the 27th September 2007, and shows the last three months of volatility data.
The red line is the HV historic volatility, and the blue line is that for IV implied volatility.
The market price of the stock is shown on the vertical axis on the left and is indicated on the graph by the black line which is blocked in pink. The current market price is $54.56. The right hand vertical axis is the volatility measure with IV currently at 22 and HV at 26. These numbers represent percentage (%). The above chart has kindly be provided by 4XFX, the premier site for options pricing and trading.
So how do we use all this information on implied and historic volatility to help us in our online option trading decisions – let’s have a look at that on the next page!