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Option Volatility

 

Volatility can be a very important factor in deciding what kind of options to buy or sell. Volatility shows the investor the range that an assetsí price has fluctuated in a certain period. The official mathematical value of volatility is denoted as "the annualized standard deviation of a assetís daily price changes."

The historical volatility for an asset relates to a past period of time. Generally, when evaluating volatility, we look at several different periods. We may look at what the volatility has been for the past week, for the past month, for the past three months, for the past six months, and so forth. The longer time period will yield more of an average volatility. When evaluating the purchase of an option, it is the historical volatility of the underlying instrument that is generally evaluated. Since the options are based on futures contracts, by having price data for the underlying futures contract, one can calculate the historical volatility.

The most commonly used model is the Black-Scholes, which is a part of most option pricing models today. By entering the futures price data, the model then calculates what the historical volatility is and can also then give you the fair market premium. In actual practice, usage of historical volatility in option pricing models such as Black-Scholes or other variations does not have predictive capability.

Implied volatility is the calculated value of volatility that yields the option price in the relevant option-pricing model. The way to solve for this implied volatility is to use our option-pricing model in reverse. We know the price of the option and all the other variables except the volatility the marketplace is using. Therefore, instead of using the equation to solve for the option's price, we use the model to solve for the option's volatility. We insert the price into the model, leave out the volatility (which we are looking for), and keep the other variables the same. It is then that we will find out what volatility will yield the current market price.

Professional option traders find it important to be able to not only know what the current volatility is, but what it is likely to be in the future. Just as market analysts will project what prices we'll see in the next few days, weeks or months, so a professional options trader will try to determine what the volatility is likely to do in a variety of time periods. The more accurate a trader is able to make this forecast, the greater the likelihood that one can earn a profit.

Forecast volatility is similar to projecting futures prices, in that one commonly looks back over the past to help determine what the future holds. And just like projecting the futures markets, projecting volatility is far from a pure science or purely mathematical. Ideally, what traders would like to know is what the future volatility is going to be. Professional option traders find it important to be able to not only know what the current volatility is, but what it is likely to be in the future. Just as market analysts will project what prices we'll see in the next few days, weeks or months, a professional options trader will try to determine what the volatility is likely to do in a variety of time periods.

The Future volatility is really more of an expression than a reality. The future volatility is simply what the volatility will be at a given point in the future as opposed to what it is forecast to be. Since we're dealing with a great deal of uncertainty and unknown anytime we project into the future, there can be no certainty to this classification. If a person actually knew without a doubt what the future volatility would be, it would be the equivalent of the person knowing exactly where the market would be on a given date in the future.

 
 
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