Two Measures of Options Volatility That Matter

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. 

Investing 101: Do Bonds Belong in Your Portfolio?

Portfolio diversification is a strategy that helps investors manage risk. Investors often choose to diversify among industries for stocks, for instance. But they also consider diversification within different assets types.

Should You Use Extra Cash to Invest or Pay Off Debt?

Deciding between repaying debt repaying versus investing may seem impossible. Everyone’s financial situation is different and only you know from an emotional standpoint what might work best. Start with your

6 Healthy Morning Rituals That Make the Most of Your Day

Whether you are a “morning person” or not, how much thought do you give to the start of your day? Do you realize that by adopting a few simple morning

How to Read and Understand an Options Quote

When you begin trading options you'll spend part of your research scanning for the right options to buy. When you find a list of options, then you'll need to learn

Test Your Financial Advisor’s Loyalty with These Simple Questions

You have a financial advisor in order to make certain you have budgeted your money correctly, have planned for future financial needs, and, in some cases, to turn some of

Sell Puts the Smart Way: Get Out Before Expiration Nears

Selling put options can be a great way to help increase the value of your portfolio without taking on too much risk. At its core, a put sale allows investors

refinancing

4 Pros and 1 Con of Refinancing Your Home

Two years ago the 30-year fixed mortgage rate was 4.6%. Today it is 2.9%. If your mortgage is in the high threes, you should consider refinancing. Refinancing would lower your

Easy Finance Tip: How to Calculate Your Net Worth

To calculate your net worth, just subtract your liabilities (what you owe) from your assets (what you own). While the equation is simple, it's important to get a snapshot of

Just a Few Bad Market Years Can Slam Your Retirement: How to Cut Your Risk

I believe one very underappreciated risk for investors preparing for retirement is the concept of “sequence of returns.” Sequence of return risk is the danger that the timing of withdrawals

Tai Chi Can Benefits for Those with Chronic Diseases

The Chinese martial art of tai chi can be beneficial to people suffering with chronic illnesses, according to research in the British Journal of Sports Medicine (2015), conducted by Dr.

Two Measures of Options Volatility That Matter

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

3 Financial Habits to Adopt Before You Retire

Nobody wants to work until the day they die. We all want to get to a point where we can simply sit down, relax, and enjoy life.  Consider adopting these