# Options - Volatility - Worth a read

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Seeing this has been discussed b4 on H/C I thought I'd repost this info just read

Worth a read

A volatile mixture
Author: Guy Bower
Date: April, 2002

It seems the more you get into options trading, the more there is to learn. Without doubt, one of the most important options topics is volatility.

While whole books and courses have been written on this subject, this article explains the basics of volatility and, more important, how to use volatility in your options trading.

But first, some definitions.

Statistical volatility

"Historical" or "statistical" volatility is a measure of the movement in the underlying asset over a period of time.

It is called historical volatility because it takes into account movement in past prices.

Historical volatility is calculated using the standard deviation of past closing prices. The measure is always expressed as a percentage. Historical volatility can be measured over any time frame, as long as you have the data, but generally speaking, a 20-day or 30-day standard deviation is the norm.

Implied volatility

Defining implied volatility takes a bit more explaining. Implied volatility is a measure that applies to each and every listed option and requires the use of a pricing model.

A pricing model is a mathematical formula used to derive a fair or theoretical value for an option based on certain inputs. Some inputs are:

The strike price.
The underlying price.
The remaining life of the option.
Whether the option is a put or call.
Upcoming dividend payments for stocks (or coupons for bonds).
Current interest rates.

Further, a measure of the degree of expected price movement, or volatility, is used in most models. The more a share price varies, the more its options would be worth. The quieter the share price, the less the options would be worth.

Pricing models such as the Black-Scholes (B-S) model require the input or all the factors listed above as well as an estimate of volatility for the remaining life of the option.

Estimating that volatility is where the skill is. That's where the concept of implied volatility comes into play.

In a nutshell, implied volatility is the level of volatility needed so that the B-S model will return a fair value of the option equal to that of the current market price. You could say that implied volatility is the estimate of future volatility made by the market as a whole.

This is an important point: each option strike has its own level of implied volatility. Think about that. If each option strike has its own premium value, then each must have its own implied volatility.

What next?

So, with all the above in mind, can we now be great volatility traders? Well not yet. First, we have to get the information and then we have to know how to use it.

For Aussie markets, the level of information availability is not that great. The Australian Financial Review publishes an "implied volatility" figure at both the bid price and the ask price for every option.

Additionally, many charting programs offer a standard deviation function taht gives you statistical volatility. For those proficient in MS Excel, the STDEV function does the same thing.

How to use it?

Here is the trick. Master this one and you will be in the top 1 per cent of traders. There are a few basic guidelines and strategies but, in all seriousness, if you follow these you will be doing better than seven out of 10 traders.

It is important to know how to interpret the numbers. That is really what this article is about. We will go through an example and examine ways to interpret the information and use in trading.

Suppose I give you a few stats on volatility. I tell you NAB statistical volatility is around 26 per cent but Qantas statistical volatility is 50 per cent. Can we make some money from either market or is it useless information?

Just like any form of analysis, be it technical or fundamental or anything, it is relative. That is where the use of past volatility figures come into play. Your trading software should be able to give you charts of past historical or implied data.

There are many things this information can offer when designing strategies. Here are some suggestions:

Where is volatility now?
What is the high and the low over a certain period?
Where does volatility consolidate?

One could argue it is a crude form of analysis, but it is effective and it can give you some idea of the type of strategies that may be suitable at certain times in that market.

News Corporation

The chart shows price and volatility information for News Corp. The chart spans one year. Each data point on the chart is the measure of historical volatility over the previous 20 trading days. That is, it shows the standard deviation of prices over this time. It is expressed as a percentage of the average price.

Back to our three questions: >

Currently, NCP historical volatility is trading around 50 per cent. What does that mean? It's hard to interpret such a figure without a standard of comparison. Knowing where the market has been can tell you if the current level of 50 per cent is high or low. It is all relative. Here you can see historical volatility of 50 per cent is rather high, but certainly not at its highest.

2. What is the high and the low over the period? Historical volatility has varied quite a bit over the past few years: from a high of more than 70 per cent down to below 20 per cent. This suggests that the share price moves from a period of inactivity and predictable movement to periods of high activity and unpredictable movement.

As options traders, the last thing we want is a market that is subdued and predictable. If that were the case, nobody would trade options.

Another reason to look at the range of volatility is that this can tell you approximately in what range volatility can move. From the chart you can get an idea of what level of volatility is unusually high or unusually low.

3. Where does volatility consolidate? The only real consolidation areas in this chart are above 60 per cent and towards 20-30 per cent. In other words, volatility has consolidated at its extremes, but not so much in between.

This is an ideal scenario for placing volatility-based trades when volume is at its highest or lowest.

For example, the period over July though September 2001 was just screaming for a "long volatility" trade.

The time frame of consolidation meant you may have been waiting for a couple of months and even had to place more than one strategy, but the pay-off was good. Volatility shot back up to more than 60 per cent.

Strategies for volatility trading

So then, what are the strategies that take advantage of volatility? Are they all those complex condors and butterflies? Well not specifically. Most strategies you mayknow of already, even the humble "long call" can be a play on volatility. The purpose of this study of volatility then is to be able to know when to place the right strategy. The methods listed below describe a few of the more common strategies.

Terms

Black-Scholes model

A popular pricing model available in most options software packages. Other popular models are the Cox, Ross & Rubenstien model and the Yates model.

Historical volatility

A measure of the degree of price movement in the underlying asset. It is measured using the standard deviation.

Implied volatility

The level of volatility needed so that a pricing model will return a fair value of the option equal to that of the current market price.

Long volatility

Describing any strategy that benefits from an increase in volatility. These strategies are best placed when volatility is low. This type of strategy may or may not be directional.

Pricing model

A mathematical formula used to derive a fair or theoretical value for any option.

Short volatility

Describing any strategy that benefits from a decrease in volatility. These strategies are best placed when volatility is high. This type of strategy may or may not be directional.

STRATEGIES FOR MANAGING VOLATILITY

Strategies for low or rising volatility

Long call or long put:both these strategies are directional plays but can also profit from an increase in volatility even if the share price does not move.

Long straddle:the long straddle involves buying at-the-money calls and at-the-money puts. Profit comes when the volatility picks up or the market moves beyond the strike price plus/minus the net cost.

Long strangle:The long strangle is much the same as the long straddle but utilises out-of-the-money options. For this reason, the long strangle is generally cheaper to place. However, since the market has to do more for the position to make a profit, there is a lower chance of success.

Bull call spread/bear put spread: as with the long call or put, these are directional positions. They involve buying a close-to-the-money call (put) and selling a call (put) further out-of-the-money. Now this is not always a preferable strategy for this scenario since volatility can affect both the long and the short leg of the trade. However, in many cases, a pick up in volatility will have a greater impact on the closer strike price option.

Strategies for high or falling volatility

Short call or put:selling at- or out-of-the-money calls or puts is a strategy that will profit from the passing of time and also from a fall in volatility.

Short straddle:just the opposite of the long straddle. This strategy involves selling out-of-the-money calls and out-of-the-money puts with the view that the market will hold steady and close to the strike price. In other words, this is a view that volatility will fall.

Short strangle:just the opposite of the long straddle. The short strangle involves selling an equal number of out-of-the-money calls and puts. The position will profit from a passing of time and a fall in volatility as the options premiums erode.

Bear call spread/bull put spread:a bear call spread involves selling a close-to-the-money call and buying a further out-of-the-money call. A bull put spread involves selling a close-to-the-money put and buying a further out-of-the-money put. The idea with each trade is that both options will expire out-of-the-money and the net premium received when placing the trade will be the profit. Falling volatility will also affect either in a positive