Option Volatility: Why Is It Important?
By John Summa, CTA, PhD, Founder of OptionsNerd.com
Volatility changes can have a potential impact – good or bad – on any options trade you are preparing to put do. In addition to this so-called Vega risk/reward, this part of the options volatility tutorial will teach you about the relationship between historical volatility (also known as statistical, or SV) and implied volatility (IV), including how they are calculated, although most trading platforms provide this for you.
Perhaps the most practical aspect of a volatility perspective on options strategies and option prices is the opportunity it affords you to determine relative valuation of options. Due to the nature of markets, options may often price in events that are expected. Therefore, when looking at option prices and considering certain strategies, knowing whether options are “expensive” or “cheap” can provide very useful information about whether you should be selling options or buying them. Obviously, the old adage of buy low, sell high applies as much here as it does in the world of stocks and commodities.
In this tutorial, we’ll look at what is meant by historical volatility and implied volatility, which is then used to determine whether options are expensive (meaning are they trading at prices high relative to past levels) or cheap. Also, we’ll look at the question of whether options are overvalued or undervalued, which pertains to theoretical prices versus market prices and how historical and implied volatility are incorporated into the story.
Another important use of volatility analysis is in the selection of strategies. Every option strategy has an associated Greek value known as Vega, or position Vega. Therefore, as implied volatility levels change, there will be an impact on the strategy performance. Positive Vega strategies (like long puts, backspreads and long strangles/straddles) do best when implied volatility levels rise. Negative Vega strategies (like short options, ratio spreads and short strangles/ straddles) do best when implied volatility is falling. Clearly, knowing where implied volatility levels are and where they are likely to go once in a trade can make all the difference in the outcome of strategy. But you first have to know what Vega is and how to interpret it before you can put it to good use.
Finally, we’ll look at uses of options volatility in relation to vertical and horizontal skews, where the implied volatility levels of each strike are compared in the same expiration month (vertical) and across different months (horizontal). This is followed by a look using implied volatility as a predictor of the future direction of stocks and stock indexes. Implied volatility can be used as a predictor of price from two angles: as a contrarian, when implied volatility has moved too far – high or low – or as a sign of potentially explosive price moves when implied volatility is extremely high for no apparent reason. Typically, the latter occurs when there is a pending unknown or even known event but it is not clear which way the stock will move. All that the extremely high-implied volatility tells you is that something big is in the offing.
In all parts of the tutorial, we’ll provide key insights and practical tips about how to use the concepts mentioned above as they relate to volatility and Vega. In the meantime, spend some more time reading and studying about volatility than trying to trade – you will not be disappointed. Good luck!