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 body. Unfortunately, too many traders launch into trading without the proper knowledge of volatility.
A misunderstanding of volatility's dynamics can lead to painful losses, which otherwise might not have been experienced. A proper understanding of volatility, on the other hand, can inject enhanced profit potential into strategies.
Toward this end, this tutorial has highlighted the following essential areas of volatility to provide a basis to explore the subject in greater depth later (see suggested resources below).
- Understanding the difference between historical and implied volatility
- Applying historical and implied volatility to pricing and valuation determination
- Getting a feel for how volatility impacts option strategies' potential risk and reward
- Acquiring insights into implied volatility skews
- Using options volatility to predict price moves
- Analyzing investor crowd psychology with options implied volatility (VIX)
To further develop you knowledge of volatility, check out "Option Volatility & Pricing: Advanced Trading Strategies and Techniques" by Sheldon Natenberg (second edition, 1994). Another recommended test is "Options As A Strategic Investment (fourth edition, 2002) by Lawrence Mcmillan. These two books should provide all the necessary concepts needed to fully understand volatility in all aspects of trading options.
Online sources of information include the Chicago Board Options Exchange website, where you can get intraday and end-of-day quotes for the VIX (implied volatility index) and other volatility indexes on major stock market averages. Additional volatility data is available at the CBOE website for individual stocks.
TradingKnowing how the market works in relation to volatility can open a whole new world of opportunity.
TradingThe estimated volatility of a security's price.
InvestingIf you can keep your head while those about you are losing theirs, you can make a nice return in roiling markets.
TradingEven if the risk curves for a calendar spread look enticing, a trader needs to assess implied volatility for the options on the underlying security.
TradingSelling a greater number of options than you buy profits from a decline back to average levels of implied volatility.
TradingThe VIX shows the market’s volatility expectations for the next 30 days.