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Educational Article

Interpreting Volatility

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Traders dreading another treatise on the VIX will be pleasantly surprised to learn that broad-market volatility is not our topic for today, while those looking for another dose can look forward to a lively discussion on the topic in this weekend's LEAPS column. I actually had intended to deal with a completely different topic today, but reader requests always come first, especially when I think they can be of benefit to all.

This reader is fairly new to the OI fold and to option trading as well, but he brings up a great point. How does the saying go about there are no dumb questions except the one that doesn't get asked? Alright, let's get to it. I've edited the question for brevity, but other than that, you get to read it just as I received it.

Dear Mark,
The site you recommended, www.ivolatility.com, is as you said. There is a wealth of information that should prove helpful. While investigating some of the calculators, I noticed, for example, that the historical volatility of XMSR was about 140, while the implied volatility of the $5 Feb. call was about 114. I first looked at this option's volatility and thought it to be extreme. Am I correct in assuming that, when compared to the historical volatility of XMSR, it isn't all that volatile? Is there a ratio an option trader should see between the two kinds of volatilities in order to view the option as not too expensive....assuming the trader is buying a call? I realize that certain types of trades are better suited to expensive options and vice/versa. But in any event, wouldn't knowing how to compare the two volatilities provide valuable information to the successful trader? I wasn't able to find an explanation of this relationship at either of the two sites and thought you may be able to provide an answer or direct me to a source. Thank you very much for your time.

Regards,
Ken

You see, it isn't enough to be able to find or calculate (for those masochists out there) a stock or option's volatility. We need to know how to interpret and use that information to improve our odds of success in this profession. But before I get to the meat of Ken's question, I know there are plenty of readers that are asking what is volatility, and how do I get one of these nifty calculators. Pardon me for taking the easy way out, but I'm going to point you to some of the articles I've written in the past that help to detail these tools and how to use them.

Varying Views on Volatility
A Primer on Online Volatility Tools - Part I
A Primer on Online Volatility Tools - Part II

Now that everyone is up to speed on option calculators and stock-specific volatility, let's delve into the details of Ken's question.

The first question has to do with the difference between historical and implied volatility. The distinction is actually pretty simple, as one deals with the underlying stock and the other refers to the volatility of the options. Historical volatility (HV) represents the volatility of the underlying stock, while Implied volatility (IV) is a measure of the volatility of a particular option. When looking at volatility charts, the IV is a calculated mean implied volatility. Of course, the ivolatility.com site gives us the ability to use the IV for calls, for puts, or a composite of puts and calls. Most of the time, there isn't enough difference between these different measures to warrant our attention, and we certainly don't want to get into that fine of detail here today. How these values are derived is really unimportant to this discussion. We want to know how to drive the car, not how to build one.

As you can tell by looking at a chart of just about any stock's volatility chart, the HV and IV values don't line up right on top of one another. Sometimes HV is higher, and sometimes IV is higher, but they tend to follow the same trend over time. What causes the discrepancy is when a stock trades in a rather narrow range (causing HV to drop) while the options still retain most of their volatility premium, likely due to other factors. For instance, a stock that trades rather flat while the rest of the market goes in the tank will see its HV drop due to the tight price action. But concern that the stock could join the rest of the market in free fall will keep option premiums inflated, and hence IV will remain high. The result is that HV will drop while IV remains high. An easing of these concerns will then have the IV drop back towards lower levels, and this can even happen with the daily price swings in the stock increasing and HV on the rise. The two measures are definitely linked, but not rigidly so.

In simple terms, I use HV to tell me how the daily range of a stock's price now relates to how it has traded in the recent past. IV tells me whether a stock's options are cheap or expensive (in volatility terms) relative to where it has been over the past 6 months, year or 2 years. As an option trader, I tend to focus almost exclusively on the IV reading, as it is a direct measure of the option I want to trade. Gaps in price can create large jumps in the HV calculation, while IV remains more of a continuous function, giving a smoother curve, making it easier to use. Not only that, but it is a more accurate representation of the vehicle I wish to trade. So, for the remainder of our discussion, I'm going to focus exclusively on IV.

The real power of volatility analysis comes in comparing current readings to where volatility has been in the past. Looking at a volatility chart of IBM, I can see IV is currently near 33%, with a 52-week range of 28%-64%.

IBM 1-Year Volatility Chart

This chart tells me that relative to the past year, IBM options are cheap relative on a volatility basis. The first piece of information this provides, is that it indicates the stock will represent a favorable candidate for strategies employing option purchases, whether puts or calls. On the other hand, a stock whose volatility is near the top of its 52-week range would present favorable trading opportunities for traders that prefer to sell option premium, whether covered or naked.

Coming back to Ken's question about XMSR, our first place to start is with the volatility chart. With IV ranging between 71%-218% over the past year, it doesn't take a rocket scientist to determine that XMSR is far more volatile than IBM. But that doesn't necessarily mean that the options are expensive on a volatility basis. Let's take a look, shall we?

XMSR 1-Year Volatility Chart

Basically, the bottom for IV over the past 6 months has been about 125%, making IV readings near that level attractive for option buyers. Take a look at a daily chart of XMSR and look at that tight consolidation action between mid-December and mid-January. That tight range allowed the volatility premium to bleed out of the XMSR options and I'm willing to bet that call purchases in the first week of January have fared rather well. In fact, even a straddle position (buy a put and a call at the same strike) using the February $2.50 strike would have fared rather well. The call could have been purchased in the first week of January for $0.60 and the put could have been purchased for only $0.30. While the put is now worthless, the recent price rise has inflated the value of the call to $2.45. A 3-week trade that yields a 172% gain is certainly nothing to sneeze at!

Certainly we didn't know whether the stock would rally or fall, but the IV chart gave us the clue that something was likely to happen in the near term when IV dropped near its 6-month lows. It doesn't always work out that way, but that's how we use volatility to help skew the odds in our favor. Take another look at that volatility chart above. Don't you think the option sellers had a field day in early August when IV began peeling off from above 200% as the stock held support near $2.70?

We've only scratched the surface here on how to use volatility in planning trades, but hopefully it gives you another tool to place in your arsenal. Questions are always welcome.

Mark



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