If you are a trader who believes that strange things happen to your positions then it can normally be attributed to volatility inflating or decreasing option premiums, regardless of whether the stock is going up or down. To make money in options you therefore can’t just rely on your view on the underlying security, you have to also think about not only the level of volatility today but also what it’s likely to do in the future.
Volatility is possibly the most overlooked factor of option trading. When you are looking at the price of an option today and its price in the future then you need to look through the eyes of volatility, and if you do not understand the impact that volatility has then you are making it difficult for yourself to get good results when trading with options.
Volatility is measured in percentage terms, so if a share is trading at $10.00 with 10% volatility then the options market is expecting the share to trade within 10% either side of that level. This is more of an expectation than a forecast. The Volatility is always changing, figures differ from day to day and a seemingly stable non-volatile stock may sudddenly become more volatile due to various factors, such as a takeover announcement or just a sudden price change. When trading options your view on the future direction of volatility is sometimes far more important than your forecast for the underlying product.
Option volatility is either historical (derived from past data) or implied (an arbitary view on future events), but generally you can see volatility by using
Bollinger bands, which were developed by John Bollinger. Bollinger Bands are an indicator that allow users to compare volatility and relative price levels over a period time. The indicator consists of a high and low line plotted two standard deviations away from a simple moving average, they are designed to encompass the majority of a stock's price movement.
In the chart of Zinifex (above) from 2006 you can see the Bollinger bands as the thick red lines above and below the share price candles. As the stock price accelerates away from the $5 level the bands move apaert, showing increased volatility, the price then consolidates around $7 and the volatility starts to subside before the race to $13 increases the volatility and the subsequent fall to $9 sends it off the dial...
The impact of Volatility on an Option Price
All options on volatile markets or stocks will inherently be more expensive than options on non volatile stocks or products. However, volatility levels can change both in the short and the long term and the trader who disregards or doesn’t take it into account is likely to struggle even if their views of the overall market direction are sound.
This means that it for any particular trade it is possible to predict the direction of the market, but if you are going against falling volatility then you may not make any profit as the gain on direction is more than absorbed by the losses caused by the volatility shrinking and reducing the premium of the option.
A simple rule to incorporate into your trading plan would be to never buy options when volatility is at historically high levels and never sell options when at historically low levels. Whatever your trading scenario or plan, the power and significance of volatility has to be respected.