“4 Must Knows About Options Volatility” continued.
In addition, the Chicago Board Options Exchange (NASDAQ: CBOE) offers a great deal of educational material on volatility such as the Volatility Finder in its Trading Tools section. This is designed to find stocks with “volatility characteristics that indicate a price move is in the works, or to identify securities whose options are under-or over-valued in relation to their near-and longer-term price history.”
To review, those are the four basics every options trader must know. Now, to profit from volatility traders must perform three separate analyses.
A) First, compare current IV with current HV. This gives an indication of how the market is pricing volatility into option prices in comparison with recent stock volatility. If the two are significantly different, an opportunity may exist to buy or sell volatility at a favorable level. Generally, if IV is above HV this is the first indication that option prices may be high. Likewise, if IV is below HV, this may mean option prices are cheap.
B) But to be sure, traders must also compare current IV with past IV. This helps a trader understand whether IV is comparatively high or low in relative terms. If implied volatility is higher than normal it may be expensive, warranting a sale; if it is lower than normal it may be a cheap buy.
C) Finally, traders need to complete their analysis by also comparing current HV with past HV. HV on the volatility chart can give an indication as to whether recent stock volatility has been greater or lower than normal. If current HV is higher than it was on average in the past, the stock is showing that it is more volatile than normal.
If the price at which an option can be traded (in terms of IV) doesn’t support the higher stock volatility, the trader must trade accordingly. That is, if IV is very low, as HV is higher than normal, it may be a buy signal.
Conversely, if HV has fallen below normal levels, traders need to observe IV to see if an opportunity to sell volatility exists. If IV is high in this HV setup, it could be a volatility sell signal.
Certainly volatility analysis is both an art and a science. This article has shown the basics for analyzing volatility. But there are a seemingly infinite series of permutations of how implied volatility and historical volatility can interact. Each volatility scenario is unique. Having a deep understanding of volatility combined with experience from putting that knowledge into practice can help traders use volatility to their advantage, and make smarter trades.
Dan Passarelli is the author of the book Trading Option Greeks and the founder of Market Taker Mentoring LLC, the leading source options education. Dan can be reached at email@example.com and can be followed on twitter at twitter.com/Dan_Passarelli.