Candlestick Trading Blog

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Option volatility is one of the most important concepts in all of options trading. An understanding of stock volatility will help a trader understand whether an option is a good value or a bad value related to the trends of the underlying stock. It is important to use sound analysis principles to understand the movement; this way an investor is better able to determine if an option is more likely to reach its expiration date in the money or out of the money.

There are two types of option volatility that we will discuss: implied volatility and historical volatility.

Implied Volatility
Implied volatility is defined as where the stock market views an option’s volatility in the future. By using a pricing model, an investor can derive the implied option volatility for the future. Together with historical volatility and theoretical fair value, implied option volatility helps identify a projected direction.

Historical volatility is the measurement of how volatile an asset has been in the past. By using a pricing model to determine the fair value of an option, it is possible to theorize whether an option is overvalued (priced above the fair value) or is an undervalued, low priced stock option. If an option is low but has a history of strong upward movement, it is likely that another upward movement is likely to occur. If the option is high, the likelihood is that the option will not sustain its high and fall due to being overpriced.

Historical Volatility
Historical volatility is a statistical calculation that tells option traders how rapid price movements have been over a given time frame. The most common technical analysis of historical volatility is called the Standard Deviation. Standard Deviation analyzes the range of a set of data points against the average. The more spread out the data, the higher the deviation. This deviation is commonly known as volatility.

The Benefit of Understanding Historical Volatility
By reviewing the historical volatility, it is possible to draw educated conclusions from your fundamental analysis about the current and future trends of an option’s volatility. Stocks that have big trends and frequent price movements are known as volatile or said to have high volatility. On the other hand, stocks whose price fluctuations are gradual and predictable are known as low volatility instruments.

The Importance of Volatility
Why is understanding option volatility so important to those who are trading in the options markets? It is tremendously important because option volatility is a way to calculate and anticipate the possible price changes of the asset in the future. Stocks that have experienced high volatility in the past can be expected to have large price changes in the future as well. As a result, options that are based on assets with high volatility can be expected to have higher prices. The higher the volatility, the more likely it is that the underlying asset will trade higher than the strike price by the expiration date. Conversely, an asset which displays lower option volatility is more likely to have a lower stock price than the strike price.

Conclusion
Calculating option volatility is another perfect example of the benefit of fundamental and technical analysis in the stock market. As an investor performs more research and looks at the tendencies and trends of an asset, he or she is better prepared to make strong moves when buying and selling, whether in the stock market or the options market. Understanding market movements, especially related to options volatility, is a key to being a successful trader in the options markets.