VOLATILITY EXPLANATION
Volatility is how much variability there is in the price changes of the stock
or index. The more variability there is, the higher the volatility.
A good rule of thumb is to see volatility as representing a 1 standard deviation
move in the stock price in 1 year. Statistically, about two-thirds of the occurrences
will be within plus one and minus one standard deviation. So, if you see a
volatility of 40%, it means that the stock will theoretically be within approximately
plus 40% and minus 40% two-thirds of the time. If the stock price is $50, and
volatility is 40%, two-thirds of the time the stock will be between approximately
$30 and $70.
The formulas that calculate the exact range are more complicated, but the above
technique is a good estimation.
Options depend a lot on volatility. When the marketplace thinks a stock will
be very volatile, the extrinsic value of options rises. When the marketplace
thinks a stock will be less volatile, the extrinsic value of options falls.
Keep in mind that it's the marketplace's expectation of future volatility that
is important. There are two types of volatility you hear about: implied volatility
and historical volatility.
Implied volatility is the volatility that, when you plug it into a theoretical
option pricing model, makes the theoretical value equal to the market value
of the option. An option pricing formula uses the stock price, strike price,
interest rate, dividends, time to expiration, and volatility to calculate a
theoretical option value.
To calculate implied volatility, you search for the volatility that would make
the theoretical option value equal to the market price. If the market price
of an option is 3.00, you find the volatility that would make the theoretical
value equal to 3.00. That volatility is the implied volatility.
Historical volatility is when you use historical stock prices and calculate
the standard deviation of the price changes. When calculating historical volatility,
you have to decide how much stock data you use. That is, do you use 1 year
of data, 6 months of data, 1 month of data? You can get different volatility
numbers for each one. If you want to use historical volatility, you have to
guess which amount of past stock data gives the best estimate of future volatility.
One thing you can do with volatility numbers is to adjust them for different
periods of time. For example, if you have a volatility of 30%, which represents
the volatility for a year, how do you calculate the volatility for a week?
What you do is multiply the yearly volatility of 30% by the square root of
the number of days divided by 365.
So, the weekly volatility would by .30 * square root of 7/365. That equals
.0415.
In one week, approximately two-thirds of the time the stock will be between
plus 4.15% and minus 4.15%. If the stock price is $50, in one week it would
be between $47.93 and $52.08 about two-thirds of the time.
For 2 days, the volatility would be .30 * square root of 2/365. That equals
.0222. If the stock price is $50, in two days it would be within $48.89 and
$51.11 about two-thirds of the time.
That's the theory, anyway. If your estimate of volatility is too low, the range
will be wider. If you estimate is too high, the range will be narrower. Also,
the statistical model used assumes that stock and index returns are normally
distributed, and that volatility is constant, that is, it doesn’t change
over time.As for option strategies that can be used to trade stocks or indices
once you’ve determined the possible range, iron condors, butterflies,
double diagonals, straddle strangle swaps, and time spreads are good choices
that have limited risk and positive time decay. RED Option has advisories for
each one of these strategies, and also supplies the probability of profit for
each of its recommendations. |
