Stocks & Commodities V. 24:7 (34-40): The Power Of Implied Volatility by Sam Bhugaloo
Do you trade beans, grains, softs, oil, or precious metals? Here’s a technique to predict market movements and price direction when trading futures and options on commodities.
Implied volatility can be used to predict whether a market is likely to move higher or lower and it can warn you against buying options that are too expensive. Implied volatility is a powerful tool and if used correctly, it will add another dimension to your trading and remove the element of guesswork. Unfortunately, many non-professional futures and options traders do not factor in implied volatility as part of their trading plan. Let me show you why they should.
HOW MUCH FROTH IS IN THIS GLASS OF BEER?
The mere mention of the term implied volatility (IV) tends to make an individual’s attention wander. The textbooks will state that implied volatility is a measure of the strike price and premium of an option in relation to the underlying futures price. It is, in effect, a measure of supply and demand for an option. This definition itself confuses the nonprofessional traders. I’ll show you how to simplify the technique and apply it through an analogy and series of charts.
Implied volatility is used to measure a market’s risk — or to simplify things, its “froth” content. What do I mean?
Here’s an example. Jack went to his local bar and ordered a pint of beer and was served more froth than beer. Like many of us would be in the same situation, Jack was displeased. Unfortunately, this is exactly what most traders go through every day. Traders will buy options with more froth than beer, and when the froth evaporates, they are left with little or nothing. The return on their investment is zero. Understanding this concept alone will first stop you from buying options that are too expensive (that is, they have too much froth), and second, if you are a futures trader, will allow you to predict the direction of the market.