Different Concepts of Volatility in Options Trading
As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running posts diving into the finer details of options education. This week, we are looking at volatility, which refers to the propensity of a security's price to move higher or lower.
Implied volatility (IV) heavily influences the price of an option, because it measures the market's expectations for the underlying equity's performance during the life span of the option. The widely accepted rule is that higher IV means bearish price action, while lower IV is associated with bullish price action. For traders, this means that in the case of a high IV, options buyers might want to steer clear, as this means a more expensive cost of entry, whereas option sellers may want to capitalize as a way of maximizing the premium collected. It's worth noting that IV tends to move higher in anticipation of major events.
Often after these major events such as a quarterly earnings report, implied volatility drops suddenly in a "volatility crush." In this scenario, the "uncertainty premium" drops out of the option price after the event. The threat of a volatility crush means option buyers should pay attention to implied volatility levels prior to entering a trade. When the disconnect between implied volatility and the actual realized movement is wide enough, option buyers can end up losing money on a trade, even if the shares are moving in the right direction. A volatility crush can also occur if there's a significant plunge in the CBOE Market Volatility Index (VIX).
Historical Volatility (HV) is a backward-looking metric, as opposed to IV's forward-looking. The most common way to calculate HV, which measures how much the stock has moved over a set time frame, is to take the standard deviation of the difference between the stock's daily closing changes compared to the mean value of the stock during that same time period. In trading, HV is often used to compare to IV in order to gauge how much volatility can be expected going forward.
For a deeper dive into volatility, the VIX, and the implications they have on the market, check out our Schaeffer's Market Mashup podcast. The episode below is a VIX round table with Cboe Global Markets, discussing the various uses of volatility in 2020.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.