# Monthly Archives: December 2011

## Option volatility and stock market volatility

Understanding Stock Market Volatility

I think that it’s important for option investors to have some understanding of basic statistics, especially standard deviation and lognormal distributions. Many option traders use volatility trading, that is they don’t trade by forecasting the direction of a stock price movement, but trade based on a forecast of the volatility. I closely monitor the volatility or standard deviation of the equities and ETFs that I trade. Basically, there are different types of option volatility that we evaluate. **Historical volatility** is the standard deviation of the past history of the underlying. **Future volatility** is what the volatility will be going forward, typically the period that is the life of the option contract. If the underlying has been through a period of low volatility you may expect it to rise, if it’s been through a period of very high volatility you may anticipate the volatility will quiet down for awhile and consider limited risk strategies that will capitalize on lowering volatility. The option investor will study the historical volatility to help determine what may happen with the future volatility. Another type of volatility is **forecast volatility** which is a forecast of what the future volatility might be. GARCH (generalized auto-regressive conditional heteroskesdasticity) models and GARCH variants can be useful tools for volatility forecasting. These three types of volatility are all related to the underlying instrument, the stock or ETF. Another type of volatility is related to the option contract and is determined by consensus of all of the participants in the market place and is derived from the Black-Scholes options pricing model and that is the **implied volatility**. When looking at a quote of an option price, check the implied volatility of the option compared to the historical volatility of the underlying. Is it significantly higher or lower? If it is, check the news wire and see if there’s a reason for the pricing. If the implied volatility is high and you’re looking at a stock check to see when the next earnings release date is or if there’s a major product announcement or lawsuit pending. When I am considering entering an option position, I’ll check the implied volatility of the options under consideration. I’ll pay close attention to the relationship between the implied volatility of the option and the historical volatility of the underlying investment. I’ll consider the current standard deviation plus some longer term history of the range and trend of the volatility. In addition to looking at the current implied volatility of the option, I’ll also look the longer term history of the implied volatility of the options. I guess we could call that the historical implied volatility. Since the implied volatility is the current volatility priced into an option, when you trade an option you are essentially making a forecast of the future implied volatility. If you think that the implied volatility is too low and will rise you should consider a strategy that will profit from rising volatility, like a long straddle if you want to be direction neutral or delta neutral. If you believe that the implied volatility is too high and that the volatility will decline in the future you should use a position that will profit from falling implied volatility like a credit spread or iron condor or iron butterfly.

Implied volatility is the one element of the Black Scholes model that must be estimated. Implied volatility can be derived from the formula using the current market price. Options that have a high implied volatility will be expensive and options that have a low implied volatility will be considered cheap. In general we want to sell something that’s expensive and buy something that’s relatively cheap. So if we’re bullish on a stock and believe that the stock price is reasonable, we’re willing to own it and we think that the option price is high due to the implied volatility, we may think it’s a good time to sell a put. If you’re bearish on a stock, believe that it is overvalued and think that the options are cheap due to low implied volatility an investor may wish to purchase a put. Conversely if you’re bullish and think the implied volatility is low you may want to buy a call. If you’re bearish and think that implied volatility is high you may want to sell a call.