Expected Stock Volatility

Option traders must have an even greater focus on volatility, as it plays a much bigger role in their profitability—or lack thereof. Because options can create highly leveraged positions, small moves can yield big profits or losses.
Option traders must monitor the likelihood of movement in the underlying closely. Estimating what historical volatility (standard deviation) will be in the future can help traders quantify the probability of movement beyond a
certain price point.

This leads to better decisions about whether to enter a trade, when to adjust a position, and when to exit.There is no way of knowing for certain what the future holds. But option data provide traders with tools to develop expectations for future stock volatility. IV is sometimes interpreted as the market’s estimate of the future volatility of the underlying security. That makes it a ready-made estimation tool, but there are two caveats to bear in mind when using IV to estimate future stock volatility.The first is that the market can be wrong.

The market can wrongly price stocks. This mispricing can lead to a correction (up or down) in the prices of those stocks, which can lead to additional volatility, which may not be priced in to the options. Although there are traders and academics believe that the option market is fairly efficient in pricing volatility, there is a room for error. There is the possibility that the option market can be wrong.Another caveat is that volatility is an annualized figure—the annualized standard deviation.

Unless the IV of a LEAPS option that has exactly one year until expiration is substituted for the expected volatility of the underlying stock over exactly one year, IV is an incongruent estimation for the future stock volatility. In practice, the IV of an option must be adjusted to represent the period of time desired.There is a common technique for deannualizing IV used by professional traders and retail traders alike.

1 The first step in this process to deannualize IV is to turn it into a one-day figure as opposed to one-year figure. This is accomplished by dividing IV by the square root of the number of trading days in a year. The number many traders use to approximate the number of Expected Implied Volatility:Although there is a great deal of science that can be applied to calculating expected actual volatility, developing expectations for implied volatility is more of an art.

This element of an option’s price provides more risk and more opportunity. There are many traders who make their living distilling direction out of their positions and trading implied volatility. To be successful,a trader must forecast IV.Conceptually, trading IV is much like trading anything else. A trader who thinks a stock is going to rise will buy the stock. A trader who thinks IV is going to rise will buy options.

Directional stock traders, however, have many more analysis tools available to them than do vol traders. Stock traders have both technical analysis (TA) and fundamental analysis at their disposal.Technical Analysis:There are scores, perhaps hundreds, of technical tools for analyzing stocks, but there are not many that are available for analyzing IV.Technical analysis is the study of market data, such as past prices or volume,which is manipulated in such a way that it better illustrates market activity.

TA studies are usually represented graphically on a chart.Developing TA tools for IV is more of a challenge than it is for stocks.One reason is that there is simply a lot more data to manage—for each stock,there may be hundreds of options listed on it. The only practical way of analyzing options from a TA standpoint is to use implied volatility. IV is more useful than raw historical option prices themselves.

Information for both IV and HV is available in the form of volatility charts, or vol charts.(Vol charts are discussed in detail in Chapter 14.) Volatility charts are essential for analyzing options because they give more complete information.To get a clear picture of what is going on with the price of an option (the goal of technical analysis for any asset), just observing the option price does not supply enough information for a trader to work with.

It’s incomplete.For example, if a call rises in value, why did it rise? What greek contributed to its value increase? Was it delta because the underlying stock rose? Or was it vega because volatility rose? How did time decay factor in? Using a volatility chart in conjunction with a conventional stock chart (and being aware of time decay) tells the whole, complete, story.

Another reason historical option prices are not used in TA is the option bid-ask spread. For most stocks, the difference between the bid and the ask is equal to a very small percentage of the stock’s price. Because options are highly leveraged instruments, their bid-ask width can equal a much higher percentage of the price.