1. Option Volatility: Introduction
  2. Option Volatility: Why Is It Important?
  3. Option Volatility: Historical Volatility
  4. Options Volatility: Projected or Implied Volatility
  5. Options Volatility: Valuation
  6. Option Volatility: Strategies and Volatility
  7. Option Volatility: Vertical Skews and Horizontal Skews
  8. Option Volatility: Predicting Big Price Moves
  9. Option Volatility: Contrarian Indicator
  10. Options Volatility: Conclusion

By John Summa, CTA, PhD, Founder of OptionsNerd.com

Volatility changes can have a potential impact - good or bad - on any options trade you are preparing to implement. In addition to this so-called Vega risk/reward, this part of the options volatility tutorial will teach you about the relationship between historical volatility (also known as statistical, or SV) and implied volatility (IV), including how they are calculated, although most trading platforms provide this for you.


Perhaps the most practical aspect of a volatility perspective on options strategies and option prices is the opportunity it affords you to determine relative valuation of options. Due to the nature of markets, options may often price in events that are expected. Therefore, when looking at option prices and considering certain strategies, knowing whether options are "expensive" or "cheap" can provide very useful information about whether you should be selling options or buying them. Obviously, the old adage of buy low, sell high applies as much here as it does in the world of stocks and commodities.

In this tutorial, we'll look at what is meant by historical volatility and implied volatility, which is then used to determine whether options are expensive (meaning are they trading at prices high relative to past levels) or cheap. Also, we'll look at the question of whether options are overvalued or undervalued, which pertains to theoretical prices versus market prices and how historical and implied volatility are incorporated into the story.

Another important use of volatility analysis is in the selection of strategies. Every option strategy has an associated Greek value known as Vega, or position Vega. Therefore, as implied volatility levels change, there will be an impact on the strategy performance. Positive Vega strategies (like long puts, backspreads and long strangles/straddles) do best when implied volatility levels rise. Negative Vega strategies (like short options, ratio spreads and short strangles/ straddles) do best when implied volatility is falling. Clearly, knowing where implied volatility levels are and where they are likely to go once in a trade can make all the difference in the outcome of strategy. But you first have to know what Vega is and how to interpret it before you can put it to good use. (For more on these strategies, see the Option Spread Strategies tutorial.)



Finally, we'll look at uses of options volatility in relation to vertical and horizontal skews, where the implied volatility levels of each strike are compared in the same expiration month (vertical) and across different months (horizontal). This is followed by a look using implied volatility as a predictor of the future direction of stocks and stock indexes. Implied volatility can be used as a predictor of price from two angles: as a contrarian, when implied volatility has moved too far - high or low - or as a sign of potentially explosive price moves when implied volatility is extremely high for no apparent reason. Typically, the latter occurs when there is a pending unknown or even known event but it is not clear which way the stock will move. All that the extremely high implied volatility tells you is that something big is in the offing.

In all parts of the tutorial, we'll provide key insights and practical tips about how to use the concepts mentioned above as they relate to volatility and Vega.In the meantime, spend some more time reading and studying about volatility than trying to trade - you will not be disappointed. Good luck!

Option Volatility: Historical Volatility

Related Articles
  1. Investing

    Options Trading: How Implied Volatility Affects Calendar Spread

    Even if the risk curves for a calendar spread look enticing, a trader needs to assess implied volatility for the options on the underlying security.
  2. Markets

    An Option Strategy for Trading Market Bottoms

    The reverse calendar spreads offers a low-risk trading setup that has profit potential in both directions.
  3. Investing

    What is Meant by Implied Volatility?

    The estimated volatility of a security's price.
  4. Trading

    Options Volatility: Conclusion

    By John Summa, CTA, PhD, Founder of OptionsNerd.com Trading options without an understanding of volatility is like operating on a patient without knowing what role blood flow plays in the human ...
  5. Trading

    Ratio Writing: A High-Volatility Options Strategy

    Selling a greater number of options than you buy profits from a decline back to average levels of implied volatility.
  6. Trading

    Option Price-Volatility Relationship: Avoiding Negative Surprises

    Learn about the price-volatility dynamic and its dual effect on option positions.
  7. Investing

    Options Volatility: Valuation

    By John Summa, CTA, PhD, Founder of OptionsNerd.comAs we've already learned, volatility comes in two forms: statistical (historical volatility) and implied (IV). We saw how past levels of IV ...
  8. Investing

    Option Volatility

    Knowing how the market works in relation to volatility can open a whole new world of opportunity.
  9. Trading

    Stock Options: What's Price Got To Do With It?

    A thorough understanding of risk is essential in options trading. So is knowing the factors that affect option price.
  10. Investing

    Option Volatility: Introduction

    By John Summa, CTA, PhD, Founder of OptionsNerd.comMany beginning options traders never quite understand the serious implications that volatility can have for the options strategies they are ...
Trading Center