« December 2012 »

IVolatility Trading Digest™

Volume 12, Issue 50
Volatility Nuts & Bolts

Volatility Nuts & Bolts - IVolatility Trading Digest

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Volatility Nuts & BoltsSince nuts and bolts hold things together, they have come to symbolize the essence or the practical basics of things, making them a perfect metaphor for our volatility review. Further, as the holiday gift-giving season is near colorful plastic ones serve as a reminder of the many kid’s toys often seen this time of the year.

The term volatility is being more frequently encountered these days especially in the financial media and because volatility comes in several different packages, all with somewhat different meanings a review of its usage should be a helpful reminder.

thinkingWhat do they mean when they say volatility is rising? In general, when referring to options, they mean options prices, called premiums, as calculated by an options pricing model, often the Black-Scholes model, are increasing. This volatility measure, called Implied Volatility (IV), is a value determined by the pricing model. Therefore, for media purposes, rising volatility means options prices are rising and the less frequently mentioned declining volatility, means option prices are declining. However, venturing beyond the headlines we find it is somewhat more complicated.

Implied Volatility for an underlying stock or an index is a derived value using an option-pricing model such as the Black-Scholes. Since the actual options prices are an input into the model, IV reflects expectations regarding the future movement of the underlying in either direction. Since option prices are a function of actual buying and selling it is a measure of uncertainty, perhaps about an upcoming earnings report, an FDA announcement, proxy vote, or a merger/takeover proposal underway.

The higher the uncertainty the more valuable the option, implying there is a much wider distribution of possible price outcomes. Visualize a flatter lognormal curve with wider tails.

As for earnings reports, the range of earnings estimates or the difference between the high and low estimate for the upcoming earnings report reflects uncertainty. Those with high and rising IV going into a report date have a tendency to show a greater divergence of opinion between the analysts, which seems very logical.

Each option contract has a unique level of IV, which changes over time as the demand for each option rises or falls. For example, differences between options that are soon to expire compared to those that will expire at a future date are often noticeable. Over a longer period, beyond a specific date, using a volatility chart will help gauge if options are cheap or expensive relative to previous levels.

The second important volatility measure called Historical Volatility (HV), also Statistical Volatility (SV) or Realized Volatility, all refer to the past price movements of the underlying asset, and hence the term "Historical" seems to remain the most popular. Usually calculated as a one standard deviation price change, computed from close-to-close price data, annualized, there is also a frequently used alternative computation method, referred to as Parkinson's Historical Volatility, Historical Volatility Hi/Low, or the range method, that includes the price range for each observation in the calculation thereby better reflecting intraday price movements.

When the financial media refers to increasing volatility they are usually attempting to describe a period of declining prices in the underlying stocks, indexes or ETFs, however when prices are rising declining volatility is less frequently used to describe the market condition, although both IV and HV have a tendency to decline when prices are trending higher.

From the perspective of an options trader or strategist, forecasted IV and HV are the most important and the least publicized. Since option premiums rise when market participants expect greater stock price movement, and since prices have a tendency to decline more rapidly rising IV is most often associated with priced declines. When the HV of a stock or index is high, there is a tendency for the market to drive option premiums high as well. Since IV is estimating the expected future HV (actual movement of the underlying) and like many most other forecasts it is often wrong due to unforeseen circumstances.

Some useful observations are helpful when attempting forecast volatility. Of most importance is the tendency to return to "normal" levels after reaching extremes, either high or low. It reverts to the mean of the current relevant period. Therefore, a strategist will tend to use strategies involving the sale of more options than those bought when volatility is high and use more long options than short options when volatility is low.

The volatility condition of the overall market will also influence the volatility of individual stocks, indexes and ETFs as well. The most widely used measure is the CBOE Volatility Index® (VIX). When in the 13 - 14 range it is usually considered low, while above 20 is high, but it often spikes upward to higher levels only to retreat just as fast while trends are harder to define.

Since HV is normally a one year, one standard deviation price change of the stock or index and IV also represents the same period they can be compared so their differences can used as the basis for preparing trading plans by determining if option prices are expensive or cheap relative to the movement in the price of underlying asset.

Although mathematically and technically incorrect, imagine this example. One way to think about the volatility relationships is by comparing local and express trains assuming express tickets sells at premiums to local tickets. Using this example, an express ticket (high IV) costs more and offers to get you there quicker. The local ticket is less expensive, but it will take longer to arrive. Imagine your delight if you bought the less expensive local ticket only to discover all the trains running that day were express. That is, the IV was either less than the HV of the underlying or the HV accelerated faster than was originally priced by the IV.

Using volatility charts showing the relationships between the two measures is the best way to estimate not only the current relationships, but keeping in mind the tendency revert to the mean from extremes, they help estimate the volatility relationships during the period of the proposed trade.

Below is a volatility chart example from our complimentary Basic Options service on our website found by left clicking on the small volatility chart in the lower right corner of the Basic Options page. Selected from Digest Issue 46 it shows a wide variance between the IV Index Mean in orange and the 30D Historical volatility in blue representing a high degree of uncertainty about the future movement of the stock price.


Daily 1 year volatility chart


Above the volatility chart at the Basic Options page there are also two tables (not shown) containing the current pricing and volume data, along with relevant Historical and Implied Volatility.

The Basic Options page default symbol is SPX, so to change it enter a new symbol and press GO! Then left click once again on the small volatility chart in the lower right corner and the new volatility chart including the important options volume along the bottom appears.

Three different periods are available, 3 months, 6 months and 1 year, which is very useful when making volatility forecasts. In addition, there are four volatility views available for each period. One each for call and puts, another combines them while the fourth is the IV Index Mean of all options.

If this is not confusing enough, here is another way volatility is used in the financial media. Since rising Implied Volatility is synonymous with increasing options prices and since one of the best applications of options are for hedging then Implied Volatility represent the cost of hedging, so IV is often used in periods of increasing uncertainty to express the rising cost of hedging.

In conclusion we suggest before making your next options trade, remember to check the volatility chart to see if it is high, low or somewhere in between.


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This is the last issue for the year. We will begin 2013 with a yearend market review along with an indicator update on Monday January 7, 2013.




Finding Previous Issues and Our Reader Response Request

All previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. Another way to find them is the Table of Contents link in the blog section of our website.

Next week's issue As usual, we encourage you to let us know what you think about how we are doing and what you would like to see in future issues. Send us your questions or comments, or if you would like us to look at a specific stock, ETF or futures contract, let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website. If you would like to receive the Digest by e-mail let us know at Support@IVolatility.com



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IVolatility Trading DigestTM Disclaimer
IVolatility.com is not a registered investment adviser and does not offer personalized advice specific to the needs and risk profiles of its readers.Nothing contained in this letter constitutes a recommendation to buy or sell any security. Before entering a position check to see how prices compare to those used in the digest, as the prices are likely to change on the next trading day. Our personnel or independent contractors may own positions and/or trade in the securities mentioned. We are not compensated in any way for publishing information about companies in the digest. Make sure to due your fundamental and technical analysis homework along with a realistic evaluation of position size before considering a commitment.

Our purpose is to offer some ideas that will help you make money using IVolatility. We will also use some other tools that are easily available with an Internet connection. Not a lot of complicated math formulas but good trade management. In addition to Volatility we use fundamental and technical analysis tools to increase the probability of success and reduce risk. We prepare a written trade plan defining why the trade is being made, what we call the "DR" (determining rationale) and the Stop/unwind, called the "SU".