Some traders mistakenly believe that volatility is based on a directional trend in the stock price. By definition, volatility is simply the amount the stock price fluctuates , without regard for direction. As an individual trader, you really only need to concern yourself with two forms of volatility: Unless your temper gets particularly volatile when a trade goes against you, in which case you should probably worry about that, too. And if there were wide daily price ranges throughout the year, it would indeed be considered a historically volatile stock.
This chart shows the historical pricing of two different stocks over 12 months. However, the blue line shows a great deal of historical volatility while the black line does not. Like historical volatility, this figure is expressed on an annualized basis. But implied volatility is typically of more interest to retail option traders than historical volatility because it's forward-looking.
Based on truth and rumors in the marketplace, option prices will begin to change. That drives the price of those options up or down, independent of stock price movement.
Implied volatility can then be derived from the cost of the option. In fact, if there were no options traded on a given stock, there would be no way to calculate implied volatility. Implied volatility is a dynamic figure that changes based on activity in the options marketplace. Usually, when implied volatility increases, the price of options will increase as well, assuming all other things remain constant. Conversely, if implied volatility decreases after your trade is placed, the price of options usually decreases.
Implied volatility is expressed as a percentage of the stock price, indicating a one standard deviation move over the course of a year. Obviously, knowing the probability of the underlying stock finishing within a certain range at expiration is very important when determining what options you want to buy or sell and when figuring out which strategies you want to implement.
Market makers use implied volatility as an essential factor when determining what option prices should be. Usually, at-the-money option contracts are the most heavily traded in each expiration month.
So market makers can allow supply and demand to set the at-the-money price for at-the-money option contract. Then, once the at-the-money option prices are determined, implied volatility is the only missing variable. Once the implied volatility is determined for the at-the-money contracts in any given expiration month, market makers then use pricing models and advanced volatility skews to determine implied volatility at other strike prices that are less heavily traded.
You can solve for any single component like implied volatility as long as you have all of the other data, including the price. However, watch out for odd events like mergers, acquisitions or rumors of bankruptcy.
If any of these occur it can throw a wrench into the monkeyworks and seriously mess with the numbers. As mentioned above, implied volatility can help you gauge the probability that a stock will wind up at any given price at the end of a month period.
How can implied volatility help my shorter-term trades? The most commonly traded options are in fact near-term, between 30 and 90 calendar days until expiration. This tool will do the math for you using a log normal distribution assumption. Then, once you have made your forecasts, understanding implied volatility can help take the guesswork out of the potential price range on the stock.
In the stock market crash of , the market made a 20 standard deviation move. In theory, the odds of such a move are positively astronomical: But in reality, it did happen. And not many traders saw it coming. Because option trading is fairly difficult, we have to try to take advantage of every piece of information the market gives us.
As you know, a stock can only go down to zero, whereas it can theoretically go up to infinity. Downward movement has to stop when the stock reaches zero. Normal distribution does not account for this discrepancy; it assumes that the stock can move equally in either direction. In a log normal distribution, on the other hand, a one standard deviation move to the upside may be larger than a one standard deviation move to the downside, especially as you move further out in time.
Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.
Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies.
Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point.
The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct.
Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy.
The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.
The Options Playbook Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between. Or why your option prices can be less stable than a one-legged duck Some traders mistakenly believe that volatility is based on a directional trend in the stock price.
Historical volatility of two different stocks. Quick and dirty formula for calculating a one standard deviation move over the life of an option Remember: Meet the Greeks What is an Index Option?More...