Options Trading: Volatility

Submitted by Stock Market News on 27 May, 2011 - 17:18

The role of volatility in options trading.

Apart from the direction of the stock market, traders also have to consider volatility. There is a limited time to the movement of the market whether, its going to rise, fall or remain in a price range . Volatility is about the fluctuation of share prices in the market that will greatly affect your profitability whether you take or write a call. If you buy an option because you think that the stock market will take off, the chances of the expected movement before the expiry date will fall if the stock becomes less volatile. This also means lower premiums, because a stock's volatility has an important effect on time value. So its important to look into volatility for the extent of your option.

Unfortunately, forecasting in the stock market is not an exact science because market conditions change daily. Traders can research all they want, but all of that just gives you past past movements not future ones. But you can use historical data to give an insight, and see what's behind the movement of price actions to know what they could mean for your trade, and how you can benefit from them.

How to deal with Volatility

You can look at the expiry date. For example if you have an option with a two month expiry, use the stock's two-month historical volatility. In a different point of view, a stock may break out and increase after a period of low volatility.

If you think that volatility will rise, option strategies fares better. A rise in volatility goes hand in hand with significant price movements. This also increases the time value of the option.

On the other hand, if you think that volatility will fall, written strategies are more suitable. Decreased volatility is accompanied by a neutral market. This reduces the time value of the option.

This may sound easy, but unexpected changes in volatility also has an affect on your strategy. Even if the market moves along as you expected, a change can be detrimental to your position. If you buy call options and the volatility falls, you will lose money, even if the share prices increase. An increase in volatility can damage a written option strategy. If you go to ASX there is a theoretical option price calculator that you can use. You can also find tools online that will show you how volatility can affect your strategy.