Trading clues from options volatility
by Dave Caplan
The significance of volatility is overlooked and underestimated by most traders in the options area.
This includes both the effect of volatility on the premium cost of an option when purchased, and the
effect of future changes in volatility on a position.
Volatility is simply a mathematical computation (I use a "modified" Black-Scholes model.) of the
magnitude of movement in an option. This is based of course, on the activity in the underlying futures
market. If the market is making a rapid move up or down, volatility will rise. In a quiet market it will be
low. I compare these readings to determine the historical volatility range, so I know whether current
volatility is relatively high or low. (See Figure 1).
I have found through our research that when volatility is at a very low level, there is a high probability of
a large move about to occur. Conversely, when volatility is at a very high level, there is a substantial
probability of the contract maintaining a trading range.
Why is that? It seems that when a contract is very quiet, traders "fall asleep" and don't expect anything to
happen. Of course, this is exactly when everything explodes! (See Figures 2 and 3.) On the other hand,
many times when the contract has been very active (volatile) for a period of time, most traders are already
in the market and it is likely to maintain a trading range. However, understanding the concept of volatility
is much easier than using it in trading.