Thursday, May 29, 2014

Profiting with Stock Option Volatility

There's been a lot of talk about volatility in stocks lately.

But today, I want to focus on options volatility and what it means for the options investor.

So let's start off with a definition:

Volatility measures the rate at which a security moves up and down. If a security is moving up and down quickly, volatility will be high. Conversely, if a security is moving up or down slowly, volatility will be low.

Options volatility is largely pinned to the underlying stock.

Traditionally, option traders look to buy options when volatility is low since premiums are lower.

And traders look to write options when volatility is high as option premiums tend to be higher.

Of course, the trick, like anything, is knowing what's high and what's low. If you're buying options with low volatility, you then want to see the volatility increase. And vice versa, when writing them.

But I do want to say, volatility is only one item in determining an option trade. Putting on an option solely because of volatility would be a mistake. But understanding how volatility affects your premium is important.

Volatility can also tip you off that something big might be getting ready to happen.

When option volatility is low, there is a high probability that a big move could be getting ready to occur.

Interestingly, when volatility drops and things are kind of quiet in the market, that's often when things heat up all of a sudden. The smart options trader will look to buy options in that environment - whether he's bullish or bearish - by buying calls or puts.

Because in addition to the option increasing in value due to moving in the right direction, it'll also increase in value because of the increase in volatility.

This happens because as volatility increases, there's an increased likelihood of rapid advances and larger price swings. That also means the higher the likelihood of an option trading in-the-money by expiration, the more it's worth to the buyer of an option.

And the writer of the option demands a higher premium for taking the other side of the trade because he's now taking more risk that he won't profit.

Looking at the other end of the spectrum, when volatility is high, or excessively high, the market is full of traders, and people are looking and expecting big things to happen.

Often times, that's when nothing happens, and the market falls into a trading range for while or slows down.

In this environment, volatility starts to shrink as the probability of large swings in the market shrinks. For the option writer, the risk of having an option he wrote get in-the-money by expiration has diminished. And for the option buyer, the chance of it getting in-the-money has shrunk as well.

As such, the writer demands less premium to cover his risk. And the purchaser pays less as his probabilities shrink as well.

So the buyer wants to see volatility trend up. And the writer wants to see the volatility trend down.

So for the writer, after volatility has trended up for a while, he will look to cash in on this by writing options as he expects volatility to cool down and maybe trend lower, increasing his chances of success.

A great way to think of volatility is this: if a security was trading at $50, and it had a 20% volatility, that means there's a greater likelihood that the security could trade within a 20% range (20% above $50 or 20% below $50) over a period of time.

That's a great way to wrap your mind around volatility.

In future examples, we'll talk about volatility and how to use it to your advantage in a practical sense.

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