Options Information -What is Volatility?

Hello, If it is March 5th in Southern California the high temperature was 40 degrees, who would put money on a bet that high would not be exceeded over the next 5 days?

How about if the high was 100 degrees? Probably a few more would be willing but in the fall it is still not as likely as it would be in August.

Well Volatility can be likened to Temperature. There is a daily average temperature and average seasonal temperature. Learning how to use these could be a valuable tool in your trading whether it be stocks, futures or options on both. There are a few types of volatility and I will briefly explain what they are. But first let's look at some definitions and how it is computed

Volatility:
Uncertainty. A measure of the stability or instability in the price of a stock, commodity or options

A probability distribution is just a frequency distribution with each frequency divided by the total number of observations. It follows that the area under a probability distribution has something to do with the probability of getting certain numbers. Volatility is nothing but for the past, the measure of frequency and for the future, the prediction of frequency. Example Bell Curve or the Game Plinko.

Historical volatility is defined as the standard deviation of the logarithmic price changed measured at regular intervals of time. Settlement prices are the most common method of computing volatility we define each price change (Xi) as:

PiXi = ln (____) Pi-1 Where Pi is the price of the underlying contract at the end of the ith time interval Pi/Pi-1 is sometimes referred to as the price relative

There are many services and programs that calculate Volatility so we will focus more on what the different types of volatility are and how we can use them.

Types of volatility
1. Historical Volatility Describes the actual distribution of prices observed during a period of time otherwise known as statistical volatility. Used exclusively for the underlying like stocks or futures
2. Future Volatilty Describes the future distribution of prices in an underlying commodity
3. Forecast Volatility An educated guess at what volatility may be for a period of time in the future.
4. Implied Volatility The level of future volatility implied by the price of an option or combined prices of options. Except for volatility, all other inputs to the options pricing model are know and defined, (strike price, price of the underlying, time, and interest rates are understood). Implied volatility is the market place's estimate of future volatility.

Volatility Chart Courtesy Moore Research

· The X Axis is the measure of Volatility and the Y Axis is the measure of time.
· the green line represents the 15 year central tendency of 20 day historical volatility (1987-2001)
· the blue lines represent 1 standard deviation from the central tendency
· the black line represents the implied volatility
· the blue line in the middle represents the current markets 20 day historical volatility
· The daily chart above displays the average historical volatility (and one standard deviation in each direction). At any given point on this line, volatility has been found above half the time, and below half the time, on average. Historical volatility has traditionally been found between the two outside bands 68% of the time. When overlaid with current implied volatilty we are able to distinguish those levels that fall outside the historical norm, creating a reference point regarding current option market prices.

Sure is a pretty chart but what do we do with it?
If you only trade futures or stocks you would use the historical volatility (red line) and compare it to the central tendency (green line) and std. Deviation (blue lines)
Notice from May through June the Historical Volatility was trading near the bottom of its std deviation and below the central tendency.
If you looked into July through August you see that Historical Volatility and the Standard Deviations increase.
What this tells us is that the markets July through August make larger moves. If through your normal analysis you can predict the correct direction than with larger moves there is a chance for bigger gains.
Bottom line: The market is telling us that historically we can expect larger moves from July through August.

Let's look at a few basic examples with options referencing the chart above. Historically though past performance cannot predict future results a seasonal period of increasing volatility through July and August.
A Basic Option Purchase might be the proper choice during this period. Pricing of options has a volatility component. So if volatility increases option premiums should also increase.
Look at what happens from mid- August through December. Implied Volatility historically trends lower or decreases. Employing strategies that take advantage of decreasing volatility should fare better than one's that take advantage of increasing volatility.
It should be noted that using volatility over time should help your options trading, however there can and will be short term periods where the market does not follow the model. With that said volatility is another tool to augment your current trading decision process.

There is a risk of loss in all futures and options trading. Options trading is complex and volatility is a complex concept. Make sure you fully understand it before using it to trade.

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