Most people often have a notion of what volatility means. They understand, at least conceptually, that it has to do with data of situations that vary over time. Weather is one example. Investments are another.
Volatility when applied to the stock market is a fuzzier concept to many. It is one of the main factors that indicate why some investments are riskier than others. It’s also the fuel that causes the premiums on options contracts to explode.
Options deal with two types of volatility. The first is historical volatility. Investors can use the returns of stocks (derived from historical stock prices) and calculate the standard deviation on those returns.
This yields a daily historical volatility measure. To annualize the result, one need only multiply by the square root of 252, which is roughly the number of trading days in a year.
It may pique your curiosity that the volatility uses the standard deviation of the stock returns rather than the variance. At the start of this article, it was discussed that volatility deals with variance.
Recall that the standard deviation is the square root of the variance. Therefore, the measure is taken into consideration. The standard deviation is used to bring the variance onto the same scale as the returns.
The other type of volatility is the implied volatility. This is the volatility that is determined based on the current premium of the options contracts. Hence, it is implied from the market.
Some investors compare historical and implied volatilities. They use the difference as the basis for determining whether an option is overpriced, underpriced, or priced to the market.
The problem with this approach is that the calculations are based on theoretical models. It assumes that these models are correct. That assumption can lead to losses.
Another way to look at implied volatility is as a guess by market participants of future volatility. If you have traded markets for any length of time, your guess becomes as good as any other market participant. They are wrong more often than they are right.
The traders who stay in the game learn how to place the odds in their favor by implementing more trades with high probabilities of success. They learn to cut their losses early.
Volatility for trading strategies
Volatility plays a role in how to structure trades. When investors find stocks with high volatility they will look for opportunities to enter positions during pullbacks of volatility. They will exit the positions when the volatility surges.
It’s an art as much as a science. Experience plays a big role in success, too.
Low volatility strategies can help bring in cash flow during the slower periods. Some investors like to use covered calls, which is an income strategy and a protective one. Other low-volatility strategies are possible, too.
Varying strategies increases the chances of making money for investors. That task is accomplished by analyzing volatility.
Volatility is one of the key elements many options investors use to help guide them on how to trade. Therefore, newer participants to the options markets should grasp the concepts of volatility and try to incorporate them into their trading strategies. Monitoring the strategies will help traders make adjustments as needed.