Pay Attention to Volatility When You Trade
Len Yates

What trader has not experienced seeing the market move in the anticipated direction, but his options gaining only very little? Betcha those options were overvalued when they were bought!
 
Or, covered writers: Have you ever written options and felt that you were getting unusually low premiums? Maybe you were selling when options were cheap!
 
Option traders measure how expensive or cheap options are using a parameter called implied volatility, or IV for short. The term implied volatility comes from the fact that options imply the volatility of their underlying, just by their price. A computer model starts with the actual market price of an option, and measures IV by working the option fair value model backward, solving for volatility (normally an input) as if it were the unknown. (Actually, the fair value model cannot be worked backward, but has to be worked forward repeatedly through a series of intelligent guesses until the volatility is found which makes fair value equal to the actual market price of the option.)
 
High IV is synonymous with expensive options; low IV is synonymous with cheap options. It is useful to plot an asset’s IV over a period of years, to see the extent of its highs and lows, and to know what constitutes a normal, or average level.
 
Another kind of volatility option traders pay attention to is called statistical volatility, or SV for short. This measures how much the price of an asset has bounced around recently. There are several different computer models for measuring SV. All of them seek to quantify the magnitude of the asset’s price swings on a percentage basis, using varying periods of the asset’s recent price history (for example, 10, 20 or 30 days). SV can also be plotted, so that the investor can see the periods of relative price activity and inactivity over time.
 
Note that what we call statistical volatility is called historical volatility by much of the industry. However, we prefer to call it statistical volatility, reserving the word "historical" for referring to the history of both IV and SV.
 
Regardless of the length of the sample period, SV is always normalized to represent a one-year, single standard deviation price move of the underlying asset. IV is also normalized to the same standard. Thus IV and SV are directly comparable, and it is very useful to see them plotted together.
 
The illustration shows the past four year history of IV and SV for Imperial Oil. Notice how high both volatilities are currently. IV, represented using the blue line, is near the high end of its historical readings at 32.5% while SV, represented using the solid line, is even higher at 42.1— a level exceeded only for brief periods only twice before.
 

Volatility Chart

 
The savvy options trader is aware of current volatility levels and adapts his trading accordingly, buying options when they are cheap, and finding ways to sell options when they are expensive. This gives him a theoretical advantage. How much of an advantage? Sometimes an enormous one.
 
For example, a near-term, ATM (at the money) call option for Imperial Oil will cost you approximately $2.00 right now. With IV at a more normal level of 20%, the same option would be worth only $1.00. To say that option buyers are facing a stiff theoretical disadvantage here would be an understatement!
 
In the current environment it would be wiser to find ways of selling these expensive options using strategies such as covered writing and covered combos.
 
Conclusion
 
Pay attention to what's happening with volatility. Each time you analyze an asset, check whether today's volatility reading is higher or lower than usual. Current volatility readings are available in any good options analysis software.
 
Someone recently compared options to a 3D chess game, and I quickly realized the validity of this analogy. In the landscape of options you have three shifting parameters: price (of the underlying asset), time, and volatility. Volatility is undoubtedly the most misunderstood and neglected, but it is important. So watch it!
 

Next time, we'll go beyond merely paying attention to volatility and discuss some of the reasons why some traders focus their attention almost completely on volatility alone.