by Tyler Craig | June 9, 2011 5:50 am
Despite the fact that option values are influenced by a number of set variables like strike price, stock price, and time to expiration, in the end they’re driven by supply and demand just like any other asset. Implied volatility is a useful metric that gives options trading investors the ability to gauge the supply/demand status of an option. If demand outstrips supply, implied volatility will rise. If supply outstrips demand, implied volatility will fall.
You may notice the term “price” could be interchanged with “implied volatility” in the prior two statements. Rather than being a mere coincidence, this speaks to the direct relationship between an option’s price and implied volatility. Namely, when all variables are held constant (stock price, time to expiry, etc.), a rise in an option’s price will result in a rise in implied volatility.
Traders use implied volatility to gauge whether an option is cheap or expensive. The phrase “buy low, sell high” is applicable here. Over time it is preferable to buy options when implied volatility is low while selling them when implied volatility is high. This is where volatility charts come in. They allow traders to make quicker, more informed decisions on whether options are cheap or expensive based on current volatility levels.
Find more option analysis and trading ideas at Options Trading Strategies.
Many option chains include a column which displays the current implied volatility of each individual option contract. While this provides a quick snapshot of where volatility is right here right now, it fails to show how volatility has evolved over time. A much more effective approach is using a volatility chart. The implied volatility of most major indexes can be viewed directly in any charting software provided you know the ticker symbol. I’ve included some examples below listing the index or exchange-traded fund with corresponding volatility chart symbols:
S&P 500 Index Options – (CBOE: SPX) — $VIX
NASDAQ 100 – (NASDAQ: NDX) — $VXN
Russell 2000 – (CBOE: RUT) — $RVX
SPDR Gold Trust – (NYSE: GLD) — $GVZ
United States Oil Fund – (NYSE: USO) — $OVX
Individual stocks and ETFs lacking their own volatility index charts like those above can be viewed elsewhere. These charts are often included in the suite of tools offered by option brokers such as ThinkorSwim and OptionsXpress. They can also be found at websites like the International Securities Exchange and IVolatility.
Of the free volatility charts available, those offered at the IVolatility website seem to have become the most popular. This is likely due in part to their clean and easy to read look. In the volatility chart below of Apple (NASDAQ: AAPL) you can see the typical default view for most of these charts. Both the implied volatility (the gold line) and historical volatility (the blue line) are included.
A key property of volatility’s behavior is mean reversion. Unlike a stock which can theoretically trend higher indefinitely, volatility tends to oscillate around some type of mean value. This is why it’s reasonable to expect volatility to fall after rising too high or rise after falling too low.
While there are a variety of nuances about the behavior of volatility that require time and experience to understand, the volatility chart is an essential tool that even the novice can use to better understand the basics of volatility analysis.
Follow Tyler Craig on Twitter@TylersTrading.
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