The last few weeks of trading have been tough to say the least. After the crash on Aug. 24 that sucked trillions from the markets in a matter of minutes, the markets clawed their way back and held their own for about a week. Then, just two days ago, they fell again, this time dropping by 3%.
It's no secret that I think this volatility will continue, at least in the short term, and the best way to weather the storm is to make sure you've got options in your portfolio.
Today, I'm going to tell you about the different kinds of volatility and how they affect the markets generally and options specifically. Then I'm going to give you a road map to deal with the volatility that I see continuing for the next few months, including a few of my favorite options trading strategies.
Let's get started…
Two Kinds of Volatility
There are two kinds of volatility that traders talk about with regard to options: statistical volatility and implied volatility. Statistical volatility (SV), also referred to as historical volatility, doesn't have much of an impact on options, but there are a few ways options traders can use it to their advantage, as you'll see in a moment.
SV is measured by the prior price moves of a stock, ETF, or any underlying security. It is typically calculated by measuring one day's closing price against the next.
It is usually shown as the standard deviation of the security's daily returns over a look-back period. It is usually an annualized number regardless of the length of that period.
When looking at options, SV can be used to compare one underlying with the other. For example, if one stock has a higher SV than the other, that would indicate a stock with more telling price moves over a given time period.
Statistical volatility has its place, but it is implied volatility (IV) that options traders are most focused on because of its impact on options pricing.
IV is a way to see what the markets expect the future volatility in the price of the stock will be between now and a particular option's expiration.
In a sense, IV is a byproduct of the option pricing model. It cannot be calculated, but once the other components are – such as short-term interest rates, time until expiry, strike, price, etc. – then the implied volatility can be assessed.
Implied volatility can be charted, so you don't have to worry about crunching all this data – your brokerage might even have it available online for you.
The list below shows stocks and their one-year IV rankings. That allows us to look at the one-year high and the one-year low, and see if a stock is currently at one extreme or the other, or somewhere in between.
You can see Abbott Laboratories (NYSE: ABT) is currently at the high range of its one-year IV. In fact, three of the top four stocks are in the same boat.
Here's How to Play Volatility
About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.