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The “V” Word: A Three-Minute Volatility Primer

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April 12, 2016

Traders talk a lot about “volatility.” What does it really mean? Loosely, stock or index volatility is the magnitude in which it moves. It also represents uncertainty about how much a stock or index price might change in the future. Volatility doesn’t care if a price change is higher or lower. Only if the change is big or small.

NUTS AND BOLTS
Putting those together, the higher the volatility, the more uncertainty the market has about the future magnitude of a stock’s potential price changes. For example, 30% vol is higher than 20% vol, and 50% vol is higher than 30% vol. But let’s add some context.

Volatility is expressed as an annual percentage number. If a stock has 30% volatility, historically the stock has shown that its price might be 30% higher or 30% lower in one year. This stock price could change more or less than 30%. But volatility suggests the price within plus/ minus 30% is the most likely scenario. Why? Volatility is also a standard deviation—which means if you believe a stock’s percentage price change is normally distributed, there’s about a 68% chance the price will be within plus/minus 30% in a year. (The 68% number comes from the normal distribution—think bell curve—and is the probability of the return of a stock price landing between -1 and +1 standard deviation.)

FIGURE 1: STRATEGY IS KEY

By viewing “Today’s Options Statistics” in thinkorswim®, you can assess the optimal strategy to use based on the current volatility against past volatility. For illustrative purposes only.

WHEN GEEK-SPEAK = STRATEGY
We assume volatility won’t change over the year, and that returns (a price’s percentage changes) are normally distributed across a bell curve. Translation? Most of the prices will cluster around a median price.

Those are pretty big assumptions. But they help you turn volatility into something concrete. Something you can use. Multiply a stock’s volatility by its price to get the one standard-deviation price change, then add and subtract that to the price. This will give you high-and-low stock prices that comprise the boundaries within which, in a year, the stock has a 68% probability of landing. You can then consider using these as price targets, stops, or even strike prices to sell spreads with potentially greater efficiency and genuine strategy.

For example, if stock XYZ was trading at \$50 and had a 20% volatility, you might target \$60 and/or \$40 as your higher and lower price targets (50 x .20 = 10) with a 68% probability that the stock will remain within that range for the year. One item of note, this probability is theoretical in nature and stocks may move outside of their one standard deviation expectation. If qualified, you could consider selling call and put spreads with your short options strikes sold at those respective targets. If a year is too long to wait, you may use the thinkorswim® probability cone on the Analyze page to help you narrow the range within the same probability.