If you are beginning to trade options, the question of volatility has surely been on your mind. As an option seller, much of my trading decisions revolve around volatility and understanding this metric is crucial for making successful trades. In this article, as the title states, we are going to go over what volatility is and why it is important if you are selling options.
Volatility Defined
To start off, I like to think of volatility as uncertainty in the market. The more uncertain we are, the more volatility there is. If we were to look at stocks and measure their uncertainty with a range from 1-10, a 1 would mean we know exactly how much the stock price is going to move, and an uncertainty rating of 10 would mean we have no idea how much the stock price is going to move. Volatility is a little more complicated than this but can be looked at similarly. To more closely define volatility we are going to look at two things, expected move, and standard deviation.
1. Expected Move
Unfortunately to fully understand volatility, we are going to have to review some math so try and stay with me on this. Volatility is an annual metric which is given as a percentage of the stock price. For example, we could say that a $100 stock has 20% volatility. What does this volatility of 20% say about this stock? Well, to make since of this header- a $100 stock with a volatility of 20% would mean that this stock has an “expected move” of $20 in said year. To clarify, this would mean a $20 increase OR decrease in the current stock price in that year. As you can figure out, having a metric which gives you an analysis of what the market expects to happen with a stock price is a game changer. Obviously, this is not 100% accurate, BUT lucky for us, volatility digs a little deeper to explain the chances of this happening and this is explained through standard deviation- our next point.
2. Standard Deviation
To review, standard deviation is a measurement of probability and I will try and make this area of math as simple as I can. As we have been over, volatility is an annual metric represented as a percentage which predicts the stocks expected move. Now adding to this definition- volatility measures this expected move within a range of one standard deviation. To review some statistics, one standard deviation measures a probability of 68%. SO putting what we have learned together we could say that a $100 stock with 20% volatility has a 68% chance of staying within a range of $80 and $120 in said year. You can imagine how useful this metric is for making trading decisions, and now we will go over the importance of this metric when we are selling options.
The Importance Of Volatility
While volatility has a lot to say about the market prediction of a stock, it is important to be aware of the role option prices have in all of this. To review, more volatility means more uncertainty. If people are more uncertain about a stock there will be more demand for option contracts (options are insurance policies for stocks). If there is more demand for option contracts, the option prices will increase. With all of that being said, the important thing to realize here is that higher volatility= higher option prices. As an option seller, you want to enter a trade at high volatility (this is when the price is high), and you will benefit when volatility decreases because this is when the option price will fall.
Summary
Volatility is one of the most important metrics when making trading decisions, and while this article was a lot of math the key points to be gained from this article should be:
- Volatility is an annual metric which measures uncertainty of a stock
- While volatility is represented as a percentage of a stock, it can be used to calculate the expected move of said stock within that year
- There is a 68% chance that the stock will be within the range determined by the expected move
- Volatility is positively correlated to option price, meaning: If volatility increases, option price increases. If volatility decreases, option prices decreases
- Our goal as option sellers is to sell at high volatility so that we can benefit when volatility decreases