Before we move to consider the practical applications of volatility to help us in our decision making, there are two other terms which help to ‘frame’ volatility and which underpin the options world. These are historic and implied volatility, and as you might expect, one is looking back at what has happened already (historic) and the other (implied) is looking forward. Both have their place, but the one most option traders focus on is implied volatility, since this is a measure of future volatility, and is therefore of much greater interest.
Here again, I do not propose to delve too deeply into the maths, so let me give you some textbook definitions.Historic volatility uses standard deviation to plot the volatility of an instrument, generally on a daily basis and annualized over a 12 month period. In other words, it is a graphical representation of the instrument based on how volatile it has been in the past. Standard deviation provides the benchmark for the calculations.
You can think of historic volatility as the instrument’s ‘footprints in the sand’ looking back.Implied volatility is very different and is forward looking. As you will see when we begin to consider the volatility indices, these are all attempting to forecast the future. Implied volatility is based on, and derived from, the underlying options prices, which are of course changing constantly throughout the day and reflecting the ever changing views of market participants. This is why implied volatility is often the only focus for options traders.
Suppose the market is waiting for a news announcement. Ahead of the news options traders will position themselves in anticipation of the release which will move the options’ prices higher or lower. Following the news, these same option traders will either sell or buy depending on their view of the market, and any reaction to the release. All of this price volatility in the options market is reflected in the calculation of implied volatility for that instrument.
To be precise, in defining implied volatility, it is in fact ‘the expected future’ volatility of the instrument as implied by the instrument’s options price. Given the formula for calculating implied volatility includes the instrument price, strike price, days to expiry, interest rates, and various other elements, you might be wondering which came first – the option price or implied volatility? And the answer is simply the market makers use the ‘at the money’ options as the benchmark and work out from there to calculate the implied volatility across the options chain.
However, I must stress, like all forecasting tools implied volatility can be wrong. It is only a tool and it is not foolproof. It is based on theoretical models, and theoretical models can and do get it wrong. So whilst it is important, and implied volatility can be used in conjunction with historic volatility to provide the ‘characteristic’ of the instrument, it is not there as a buy or sell signal.
It is there to provide another piece of the jigsaw in your trading analysis – an important piece, but one which is not perfect.So how do we interpret historic and implied volatility, and all the other applications of volatility we have discussed thus far? I will show you where to find all the information along with the volatility charts, which are generally freely available. There are one or two sites which offer more advanced charts as you develop your binary options skills.
Historical and implied volatility analysis is only one aspect of volatility to consider – there are others which we will look at next, starting with some simple, quick and easy ways to use and interpret volatility in all timeframes and markets.Getting Started:As I have mentioned before, volatility is a tricky and complex subject, and one on which there are a multitude of approaches and analytical techniques.
The maths on many of these is complex, and only applicable if you are proposing to write about options theory. My purpose here is to try to guide you to those practical applications which will help in your trading decisions. Some of these are very simple, others are more complex, but all I hope will help to provide you with that extra insight you need to trade binary options successfully.
And the starting point is to use one of the simplest volatility measures of all, namely the high/low price we touched on in the True Range calculations. This is one of the simplest measures of volatility, and the best place to start I believe, as we begin to add volatility to our decision making trading toolkit.