There's been a lot of talk about volatility in stocks lately.
But today, I want to focus on
volatility and what it means for the options investor.
So let's start off with a definition:
Volatility measures the rate at which a security moves up and down.
If a security is moving up and down quickly, volatility will be
high. Conversely, if a security is moving up or down slowly,
volatility will be low.
Options volatility is largely pinned to the underlying stock.
Traditionally, option traders look to buy options when volatility
is low since premiums are lower.
And traders look to write options when volatility is high as option
premiums tend to be higher.
Of course, the trick, like anything, is knowing what's high and
what's low. If you're buying options with low volatility, you then
want to see the volatility increase. And vice versa, when writing
But I do want to say, volatility is only one item in determining an
option trade. Putting on an option solely because of volatility
would be a mistake. But understanding how volatility affects your
premium is important.
Volatility can also tip you off that something big might be getting
ready to happen.
When option volatility is low, there is a high probability that a
big move could be getting ready to occur.
Interestingly, when volatility drops and things are kind of quiet
in the market, that's often when things heat up all of a sudden.
The smart options trader will look to buy options in that
environment - whether he's bullish or bearish - by buying calls or
Because in addition to the option increasing in value due to moving
in the right direction, it'll also increase in value because of the
increase in volatility.
This happens because as volatility increases, there's an increased
likelihood of rapid advances and larger price swings. That also
means the higher the likelihood of an option trading in-the-money
by expiration, the more it's worth to the buyer of an option.
And the writer of the option demands a higher premium for taking
the other side of the trade because he's now taking more risk that
he won't profit.
Looking at the other end of the spectrum, when volatility is high,
or excessively high, the market is full of traders, and people are
looking and expecting big things to happen.
Often times, that's when nothing happens, and the market falls into
a trading range for while or slows down.
In this environment, volatility starts to shrink as the probability
of large swings in the market shrinks. For the option writer, the
risk of having an option he wrote get in-the-money by expiration
has diminished. And for the option buyer, the chance of it getting
in-the-money has shrunk as well.
As such, the writer demands less premium to cover his risk. And the
purchaser pays less as his probabilities shrink as well.
So the buyer wants to see volatility trend up. And the writer wants
to see the volatility trend down.
So for the writer, after volatility has trended up for a while, he
will look to cash in on this by writing options as he expects
volatility to cool down and maybe trend lower, increasing his
chances of success.
A great way to think of volatility is this: if a security was
trading at $50, and it had a 20% volatility, that means there's a
greater likelihood that the security could trade within a 20% range
(20% above $50 or 20% below $50) over a period of time.
That's a great way to wrap your mind around volatility.
In future examples, we'll talk about volatility and how to use it
to your advantage in a practical sense.
You can learn more about different option strategies by downloading
our free options booklet: 3 Smart Ways to Make Money with Options
(Two of Which You Probably Never Heard About).
Just click here.
Disclosure: Officers, directors and/or employees of Zacks
Investment Research may own or have sold short securities and/or
hold long and/or short positions in options that are mentioned in
this material. An affiliated investment advisory firm may own or
have sold short securities and/or hold long and/or short positions
in options that are mentioned in this material.
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