Secret sauce of option trading — volatility
Hi there! This is Sushant from Big Blind series on options trading. In this tutorial I’ll talk about the most important weapon of an options trader — volatility. Understanding volatility is the fundamental core of trading options.
What is volatility?
Volatility is a measure of movement in stock price in either direction. Greater the movement, higher is the volatility. To understand this better, let’s look at an example of carom table.
Imagine hitting a striker hard to open up the set-pieces on a carom table — if all pieces move far away from each other in all directions, you can say that your hit created a ‘high volatility’ situation. On the contrary, if coins stay largely unmoved after your hit, you have created a ‘low volatility’ situation.
Volatility is a measure of dispersion of stock price— greater the stock price variation, higher is the volatility
Why does volatility matter?
As we looked at in our previous tutorial, volatility is a friend of an option buyer. Higher the volatility, greater is the option price and hence, greater is the profit potential for a buyer.
We discussed why this is the case — greater the volatility, higher the dispersion — high dispersion means that a stock can move way above or way below its current price.
Since an option buyer has an unlimited upside and limited downside (remember, maximum downside is the premium paid upfront), an increase in volatility helps in increasing the likelihood of a maximum upside scenario. So whether its a call or put option, increased volatility increases likelihood of a huge increase or decrease in stock price respectively. And when that happens, an option price is bound to increase.
Conversely, an option seller wants volatility to come down — a low volatility scenario reduces the likelihood of a large movement in stock price. This scenario increases the profit likelihood of an option seller.
Increase in volatility helps an option buyer and decrease in volatility helps an option seller
How is volatility measured?
There are 2 types of volatility that can be measured — a) historical volatility b) implied volatility.
Historical volatility is the volatility calculated by computing the daily variation in stock price over the last 1/3/6/12 months or any other time horizon one chooses. In mathematical terms (don’t bother if you aren’t good with math & statistics), volatility is measured as standard deviation of daily returns computed over a given time horizon.
Historical volatility is a measure of stock variation based on the past behavior of stock prices over a given time horizon
Implied volatility as the name suggests is the volatility ‘implied’ by the current market price.
Let’s understand this better — every option has a market price based on what buyers and sellers are willing to pay and receive respectively. As we understood in previous tutorials, an option price is dependent on current stock price, strike price, time to expiry and volatility. Stock price, strike price and time to expiry are fixed parameters with no ambiguity whatsoever. Only parameter that is ambiguous is the expected volatility in stock price from current date to expiry date.
An option buyer and seller are implicitly betting on the volatility in stock price from current date to expiry date.
Essentially, a buyer and seller is taking a view on the future volatility of stock price (between now and expiry date) when they agree to trade with each other at a market price. Volatility implicitly assumed by a buyer/seller to arrive at a market price is called as an implied volatility.
Volatility implicitly assumed by an option buyer/seller when they agree to a market price is called implied volatility
To summarize, we have introduced two terms — historical and implied volatility. Historical volatility is a measure of variation observed in stock prices over the past & implied volatility is a measure of stock price variation implicit in the current market price of options. We will do a deep dive into volatility in our future tutorials — if it is still a bit hazy, please bear with me for the next 2–3 tutorials. I promise, things will get a lot clearer as we go along.
I hope this tutorial on volatility was helpful — please leave your comments and feedback in the section below.
