Of the factors that go into trading options (and there are a lot of which!), volatility has become the most under-utilized and least understood by beginning traders. Most traders unfamiliar with option trading will focus solely about the immediate price of the underlying asset (ie the share price or futures price). They don’t think about that volatility values go deep into calculating the price of the possibility. However, professional traders will focus much more heavily around the volatility of the underlying asset and then make their decisions accordingly. The truth is, many professional traders claim that volatility trading is much like trading in slow motion…how easy does that seem?
Here is the estimated volatility of your security’s price live, or as being the option trades. The IV values are produced from formulas that measure just what the options market expects and attempts to predict what the underlying asset’s volatility is going to be over its life. These values tend to fall when the asset is within an uptrend and rise when the market downtrends. Mark Powers, in Starting Out In Futures Trading(McGraw-Hill), describes IV as an “updated reading of methods current market participants view what will probably happen.”
This is also known as statistical volatility (SV). This kind of volatility can be a measurement in the movement of the cost of a financial asset as time passes. It is calculated by figuring out the typical deviation through the average price of the asset in the given period of time. Standard deviation is considered the most common strategy to calculate historical volatility.
HV measures how quickly prices in the underlying asset happen to be changing. It is stated like a percentage and summarizes the current movements in price.
HV is always changing and needs to be calculated each and every day. Because it can be very erratic occasionally, traders tend smooth out your numbers through a moving average of the daily numbers.
At most of the times, IV and HV will vary in value. If the was really a perfect world, they should be fairly close together, since they are supposedly measuring two financial assets that are very closely related to one another (ie the possibility itself and the underlying asset). However, you will find often where these values will be quite different, and it is these times that can provide some exciting best ideas for trading. This really is a concept called “options mispricing” and having the capability to appreciate this concept may be of great assistance with your trading decisions!
In later articles, I am going to be looking at how you can use this understanding of volatility to effectively trade options over longer amounts of time with a great degree of accuracy.