Of all of the factors which go into trading options (and there are plenty of those!), volatility has become the most under-utilized and least understood by beginning traders. Most traders unfamiliar with option trading will focus solely about the immediate value of the actual asset (ie the share price or futures price). They don’t take into consideration that volatility values enter into calculating the need for the option. However, professional traders will focus much more heavily about the volatility in the underlying asset to make their decisions accordingly. In reality, many professional traders claim that stock market is a lot like trading in slow motion…how easy does that seem?
This is basically the estimated volatility of your security’s price in real time, or as the option trades. The IV values are based on formulas that measure just what the options market expects and attempts to predict what the underlying asset’s volatility will likely be over its life. These values often fall once the asset is in an uptrend and rise if the market downtrends. Mark Powers, in Beginning In Futures Trading(McGraw-Hill), describes IV for an “up-to-date reading of methods current market participants view what is probably going to happen.”
This is also called statistical volatility (SV). This type of volatility is really a measurement of your movement of the cost of a financial asset as time passes. It can be calculated by identifying the average deviation in the average expense of the asset from the given timeframe. Standard deviation is considered the most common strategy to calculate historical volatility.
HV measures how fast prices in the underlying asset happen to be changing. It really is stated being a percentage and summarizes the recent movements in price.
HV is usually changing and must be calculated each and every day. Because it could be very erratic occasionally, traders tend smooth out of the numbers simply by using a moving average of the daily numbers.
At most times, IV and HV are different in value. If the was actually a perfect world, they should be fairly close together, since they are supposedly measuring two financial assets that happen to be very closely related to one another (ie an opportunity itself and also the underlying asset). However, you will find often where these values is going to be quite different, in fact it is these times that will provide some exciting best ideas for trading. This can be a concept called “options mispricing” and having the capacity to understand this concept can be of great assistance in your trading decisions!
In later articles, I am going to be looking at how this can be used knowledge of volatility to effectively trade options over longer periods of time having a great amount of accuracy.