Volatility 101: The basics of options trading

By admin
In March 20, 2014
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Options can be a wonderful tool to help an investor with portfolio hedging, to create extra income, even to speculate on a market trend.

But before you can trade options on the stock price of Apple or Tesla, you have to understand the basics of volatility. To do that, we’re going to break down volatility into a three step recipe, which should be as easy as baking pie.

Step 1: Understand the definition of volatility
(The crust)

On the outset, volatility can sound like a bad, scary word when it comes to investing. But in its simplest form, volatility has the following definition:

Volatility is the standard deviation, or variance, between returns from the same security or market index. Generally, the more variance a security has in its returns, the riskier the security.

Step 2: Understand the difference between past and future forms of volatility
(The filling)

  1. Realized volatility
  2. Implied Volatility

Realized volatility is a rear facing measure of what volatility actually occurred for a given time period.  It is also known as historical volatility.  So a 30-day realized volatility is a rolling measure of how an instrument moved over the past 30 days.

Implied volatility is the expectation of volatility that is priced into options. In other words, it is the forward view of actual volatility that option market participants are pricing into calls and puts. The key here is that this number is neither right, nor wrong, at the moment of measuring – it is only a perception of where the actual volatility might be. So 30-day implied volatility is a rolling measure of the perception of volatility for the next 30 days, as depicted by options with roughly 30 days to expiry.

Step 3: Putting it together
(Assembly)

Before considering buying an option, we need to know the full volatility picture of a security that we might be considering trading. The same way a fundamental investor needs to be sure he or she is not paying too high of a price earnings multiple (PE) for a stock; we also need to make sure we are not paying too high of an implied volatility for our options.

A real life way of understanding implied volatility is to think of housing insurance.  A house in Florida may cost $1,000 a year to insure. The exact same house, with the exact same value, in Toronto may only cost $300 to insure because Toronto doesn’t have the same hurricane risk. The insurance on the Florida house has a much higher implied volatility than the one in Toronto. This is because the insurance company must charge you a premium for the increased risk of a storm.

In the same way, an April put on a Tesla stock will cost you more as a percentage of the stock price than a similar put (in terms of percentage from stock price) on Apple – there is the perception that Tesla can move much more than Apple over time; therefore, the options market has priced in a greater ‘potential’ movement in the stock.

What’s the cheaper option?  It depends on the realized volatility and how it compares to implied volatility on a relative basis.  If the Tesla stock price is moving around significantly, the options, while expensive compared to Apple options on an absolute basis, may actually be cheap.  Likewise, if Apple’s stock price has not been moving very much, the options, while cheap on an absolute basis, may actually be expensive.  So we must know both historical and implied volatility and how they relate to each other to form the bigger picture.  Whether buying or selling options, make sure you know the bigger volatility picture.

(Source: Horizons)