Volatility explained

Whoever said the only things certain in life are death and taxes wasn’t a trader. Otherwise, they would’ve included volatility.

If you’ve ever wondered why stock prices move up one day and down the next, you’re not alone. Sometimes it’s obvious, other times not. Sometimes it’s a little, other times it’s a lot. If you want to take your option trading to the next level, it’s a good idea to understand how volatility impacts your option trades before and after you get in.

Volatility is nothing more than a measure of how much something moves.

When traders talk about volatility, they’re generally talking about one of two things: the market/stock volatility as a function of price swings, or the implied volatility of options as a function of the price of options themselves. This is an important distinction.

Market or stock volatility comes as a result of the price swings you see on a daily basis. It’s real, measurable and, most importantly, it has already happened. Traders refer to this as “historical” or “realised” volatility. It’s a measure of past volatility of the overall stock market, sector or individual stock.

With a stock, it’s a measure of how much its price changes in a given period of time. When a stock that normally trades in a 1% range of its price on a daily basis suddenly trades 2-3% of its price, it’s considered to be experiencing “high volatility.”

On the other hand, “implied volatility” is the market’s perception of how much a stock—or the market itself—will move, and is reflected in the price of its options. Think of implied volatility as the options market’s best guess at future volatility. As with any guess, it’s not guaranteed it will hold true. Presented in percentages, an option with an implied volatility of 35% is saying that the underlying stock is expected to stay within a 35% (high to low) range over the next year.

For example, let’s say our theoretical company Tiger, Inc. is trading at $100 per share and has an implied volatility of 35%. This means the options markets are forecasting that Tiger could move up or down $35 in the next year. This would create an expected range of $65 to $135 for Tiger over the next year. Meanwhile, the options prices for Tiger will reflect this expected price range. Think about it - if Tiger is not expected to trade above $135 or below $65 in the next year, any option outside that range will be relatively cheap. This is because the probability of those options being in-the-money are, for the moment, low.

Traders will buy up protection by hedging with puts or speculate by buying more calls, in response to imminent events that bring a higher level of uncertainty (such as company earnings releases, economic data reports and political elections, among others). As a result, traders expect, at least for the short term, larger moves in stocks. As demand increases for the options on those stocks, their implied volatility generally increases and options prices tend to rise. When those events pass or news comes out, the uncertainty dissipates and implied volatility usually falls, along with option prices.

To find the implied volatility of an option on Robinhood, follow these steps:

1. Tap the Search icon at the bottom of your app
2. Search for a stock symbol
3. In the Stock Information Page, tap Trade, then Trade Options
4. Select the expiration at the top of the screen
5. Select the option from the chain you want to trade
6. Under “Limit Price,” select the bid/ask and you’ll see this:

If you’ve ever bought a call and watched the stock go up, only to watch your call go down in value, you’ve more than likely experienced a “volatility crush.” Think about volatility like a rubber band - when it’s stretched it tends to be temporary and, at some point, it snaps back. In trader-speak, this is called “mean reversion.” It’s a good idea to be mindful about buying calls and puts on high-volatility stocks, particularly around events like earnings, economic news and other market-moving events.

The good news is that there are plenty of option strategies that are designed for both high and low volatility markets. Following the simple “buy low, sell high” mantra, many traders employ...

• buy strategies, like long calls and puts or debit spreads, when volatility is low
• option sell strategies, such as cash-secured puts or credit spreads, when volatility is high.

How do you know when volatility is high? After all, the implied volatility of an option in and of itself doesn’t tell you much. There’s nothing that says 95% implied volatility on a stock is high, or 35% is low. To find out, you’ll need to compare the current implied volatility to its historical levels, or peripherally to a volatility index (like the Cboe Volatility Index (VIX) or the Cboe Nasdaq 100 Volatility Index (VXN)). Often called the market’s “fear gauges,” both of these indices measure the implied volatility of the options that trade on their underlying indices - the S&P 500 and Nasdaq 100 respectively.

Checking and understanding option volatility might take some time but it’s worth it. Once you understand where it sits (along with price and time to expiration), you can choose a more optimal strategy based on market conditions. New options traders make common mistakes that might be avoided by taking some time to analyse whether an option is cheap or expensive, relatively speaking.

Next up: Trading Calls and Puts

Important information

When you invest your capital is at risk. Past performance is not a reliable guide to future gains. Your investments and the income you receive from them may go down as well as up so you may get back less than you invest.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information purposes only and does not constitute financial advice. Any hypothetical examples are provided for illustrative purposes only. Actual results will vary.

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