V.6:7 (259-261): Trading clues from options volatility by Dave Caplan

V.6:7 (259-261): Trading clues from options volatility by Dave Caplan
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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.

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