Trading options volatility
by Andrew J. Sterge
Options are much more than a hedging vehicle or leveraged way of participating in spot or futures
markets. Indeed, options create strategies that did not exist before in trading an option's underlying
instrument. These strategies are known as volatility trades and the benefit is that you usually don't have to
pick market direction, something always tough to do. Instead, you bet on whether an option's volatility is
cheap or rich, in other words, undervalued or overvalued.
The term volatility is used with abandon in discussions of options, this one included. All traders can tell
by feel whether or not a market is volatile, but making the term mathematically precise is another matter.
The problem arises because the usual definition of volatility — the standard deviation of daily percentage
price changes — assumes these percentage price changes are normally distributed, that there are few lows
and highs and mainly middle values. Yet it is well-documented that this assumption is incorrect.
To be specific, traded instruments typically exhibit more very large and more very small price changes,
but fewer intermediate-sized price changes, than would be expected if the price changes were normally
distributed. Therefore, a 25% 30-day historical volatility, for instance, probably reflects a few large and
many very small price changes rather than the more uniform behavior of a normal distribution with 0.25