In the world of options trading there are two prime concepts which all traders have to embrace in order to succeed. The first of these is time. The second is volatility. No book on options, whether binary options or exchange traded options, would be complete without a chapter explaining volatility. It is time and volatility which together underpin the options instrument, and its associated reaction to the underlying market.
As we have already seen, time is a critical element in the options world. It is a wasting asset, and when considering any option is a prime factor in the decision making process. The wasting aspect of time can work both for us and against us. If the binary option is deep in the money then it’s working for us. Alternatively, if a binary option is deep out of the money, then it is working against us, and the closer we move to the expiry of the option, the faster the time element erodes. Time then has two sides – good and not so good, and the same applies to volatility.
There are times, as an options trader, where volatility is very welcome, but there are others where volatility is the last thing we want to see.Before we explore what we mean by the word volatility, let me just plant this image in your mind, which I hope will help to provide a visual picture of the relationship between price, time and volatility.It is this simple triumvirate of time, volatility and price which lies at the heart of binary options and the associated probabilities which are then quoted on the order ticket.
Of these, volatility is perhaps the most complex to understand, and least understood. However, my purpose here is not to delve deeply into the world of the Black Scholes options pricing model – a quick Google search will deliver all the information you could possibly want on the subject, and from a range of learned scholars. My objective in this chapter is to try to deliver something which is a little more practical, perhaps more straightforward, and which does not require a degree in higher level mathematics.
In other words, an understanding of volatility in simple terms which can be applied easily, quickly and perhaps, more importantly, practically to help you in assessing risk when trading binary options. Binary options by definition are short term instruments, and whilst weekly vanilla options are a relatively new addition to the trading world, historically longer term timeframes have been the norm. And whilst some would disagree, volatility and risk in my opinion go hand in hand. We’ll explore this in more detail throughout this chapter.
But let’s start by trying to arrive at a simple definition of volatility, which is perhaps the most overused, mis used and abused word in the trading world. And this is where the problems begin.Volatility is one of those concepts and terms which is immensely difficult to pin down. It is a word which is used in many different fields and interpreted in many different ways. We talk of people being volatile, having an explosive temper – of chemicals being volatile, and of governments and countries being volatile, and perhaps herein lies the core principle of volatility.
Volatility describes movements, actions or events which are considered to be sudden, and by implication, these actions and events are ‘extreme’ and so bring distance into the volatile equation. The two principles of volatility, purely from a common sense approach, would therefore suggest a sudden extreme movement could describe the word volatile. Not very scientific perhaps, but a workable description.And here, it is important to state what volatile does not describe when applied to the trading lexicon, and that’s direction.
Volatility is a non directional measure. It says nothing about the direction of any price move either higher or lower, and in fact the market may simply move sideways in a whipsaw phase.To summarize, volatility in a simple and common sense way, is simply a statement the market has seen sudden and extreme movements in price. It is bringing together the elements of time and price on our see-saw as shown in Fig. 7.10.
As volatility increases, time and price are compressed and the easiest way to think of this is to consider a market, a stock index for example, such as the Dow Jones or the S&P 500. Suppose the Dow Jones moved an average of 100 points per day and over a week perhaps an average of 350 points higher or lower. Now imagine the index moved 350 points in one day. A week of price action has been compressed into a single day.
Time and price have been compressed and this, in a sense, is really what volatility is all about. It is the constant compression and expansion of time and price that leads to the constant changes in volatility in the market. You can think of this like an old fashioned bellows, sucking air in slowly, before driving it out fast to fan the flames of the fire.