Why Is Volatility Important?
If you spend any time studying options, you’ll consistently come across the concept of volatility. Actually, volatility has become a widely followed market indicator. So, it’s not just an obscure options topic anymore.
In fact, it’s very normal to see quotes on the CBOE Volatility Index (VIX) flashed across the major financial news networks. The VIX measures the average volatility of S&P 500 stock/options – so it makes a reasonable indicator of overall market volatility.
So why is volatility so important to options traders?
First off, volatility is the measure of the variation of a financial instrument over time. In other words, it’s a metric for measuring how much a stock or option (or something else) moves over a certain period of time.
The higher the volatility, the more the instrument moves on average. Keep in mind, moving doesn’t necessarily mean just up or down. A stock could move both up and down quite a bit in a period and still be volatile.
Here’s the thing…
Volatility is a key component in options pricing.
The volatility of an underlying has a significant impact on the price of just about every option. Two options with the same strike, same underlying price, and same time to expiration could be vastly different in price depending on volatility.
Just as importantly, future volatility is basically the one factor in an option’s price that is just an educated guess. You can look up historical volatility, but volatility on options which expire at some point in the future is unknown.
As such, traders often disagree with the current (or implied) volatility of options. If you think the market has priced an option too high or too low (because of volatility), you might buy or sell an option as a result.
Now, I’ve just given a very simple view of volatility. But, the underlying theory will hold true despite how complex the scenario becomes. Essentially, buying or selling options based on your prediction of volatility is a perfectly legit strategy.
Several options strategies are designed specifically to trade volatility without being exposed to market direction. But, that’s an article for another time.
Yours in Profit,
Gordon Lewis
Category: Options Trading
