Volatility has become easy shorthand for trading talk. But just below the surface, volatility can be confusing. Yet, when you look at it through different lenses, a few basic truths start to clear things up.
In the old days, the gulf between retail investors and professional traders was as wide as the Grand Canyon. If he or she traded at all, the average investor had delayed quotes (ugh), slow fills (double ugh) and couldn’t even spell “volatility.” The pros had a distinct advantage. Yet, thanks to leaps in retail-trading technology and education, retail traders are often playing on an even field with the pros.
One of the big changes is in retail traders’ knowledge of volatility and how they use it. Many traders now monitor the CBOE Volatility Index (VIX), and try to choose the appropriate tactic for a given level of volatility. They even know what “implied volatility” (IV) is. Who’s the pro now? As a result, volatility has become shorthand for trading discussions among retail investors.
This makes sense because mechanically, volatility is a by-product of price information. Implied volatility, for example, is derived from current option prices via a pricing model. In one respect, then, volatility and option price are one and the same, and volatility can inform you about option prices. But in other respects, they’re not the same. And seeing volatility and price as equal can be misleading. That’s where you have to apply a different lens that will help you focus in on volatility in a different way.
What tends to get the market’s attention? Monster stocks over $300 moving $20 or more in a trading day. That can be a lot of money if you’re invested in a stock like that—a $2,000 move for 100 shares. But does that mean that all the opportunity is in high-priced stocks?
Well, $20 moves may seem like a lot, but don’t confuse dollar changes with percentage changes, which is what volatility is all about. Let’s do a little math. If volatility is 20%, that means theoretically the price of the stock will be between +/- 20% from its current price 68% of the time (one standard deviation) in one year. If the current stock price is $600, that 20% translates into +/- $120. If the stock price is $50, 20% is +/- $10. Simple enough. Understand that a $2 move in a $50 stock is a larger percentage change (4%) than a $20 move in a $600 stock (3.3%). If you invested say, $5,000 in each trade, in this example you actually made more in the $50 stock because you would have purchased more shares.
To take it one step further, because stock price is an important variable in any option-pricing model, the option prices on a higher-priced stock will be greater than the option prices on a lower-priced stock—volatility and all other things being equal. You’ll see out-of-the-money (OTM) options on that $600 stock that have what look like high premiums compared to the options on that $50 stock. So, just because an option on a high-priced stock has a higher price too doesn’t necessarily mean you have the potential to make more with a high-dollar move in a monster stock. In fact, it’s the capital requirement on those high-priced stocks that can be the problem.
The capital requirement on a short put, for example, is based in part on the stock price. The higher the stock price, the larger the required capital to short a put. Are you using your trading capital efficiently if you’re selling high-priced options in high-priced stocks? Not necessarily. If the options on a $50 stock have a higher IV than the options on a $600 stock, you might consider shorting 10 OTM puts on the $50 stock rather than 1 OTM put on the $600 stock. Just keep in mind there will be more transactions costs when there are more contracts involved.
In fact, for the same amount of capital required to short an option on a high-priced stock, you might consider either trading more contracts of a lower-priced stock with higher volatility, or even trade fewer contracts, require less capital, and use the rest to diversify more.
What does the lens of trading capital show? In a word, don’t get seduced by big swings in high-priced stocks and option premiums.
If I tell you that stock XYZ’s options have an overall IV of 40%, can you tell me if that’s high or low? Of course not. Not without knowing anything about the range that the volatility has had in the past, or where it is relative to other stocks in its industry sector. A lot of traders monitor the VIX, which is a measure of the IV of SPX options, and compare the IV of an individual stock’s options to it. But if the VIX is 15%, does that mean that 30% vol in a stock is high, and creating opportunities? Not necessarily. You need to compare the current IV to past IV to better judge if it’s high or low right now.
There are a couple of things you can look at to help you determine this on TD Ameritrade’s thinkorswim® platform.
1/ Options Statistics Look under the Trade tab, in “Today’s Option Statistics.” (Figure 1) The Current IV Percentile shows you IV today compared to the high-and-low range for the past 12 months. A 50th percentile means IV is exactly in between the high and low values. A percentile closer to 0% means vol is low relative to where it’s been in the past 12 months. A percentile closer to 100% means vol is high relative to where it’s been.
FIGURE 1: IS VOLATILITY HIGH OR LOW? From the Trade page of thinkorswim, you can view current volatility relative to its recent past and compare it to other expirations. For illustrative purposes only.
2/ thinkorswim Charts Under the Charts tab, pull up a volatility chart on a stock to show you the daily IV going back as far as seven years. (In the upper right of a chart, click Studies, then ImpVolatility in the drop-down menu.) You can see the current IV on the right hand side, and compare it to its high-and-low values for short- and long-term ranges.
Using the probability of an option expiring in, or out of, the money to choose a trading strategy is something that many retail investors now do routinely. Yet, are equal probabilities actually equal? Thinkorswim makes finding that answer easier with the “Probability OTM” and “Probability ITM” columns on the Trade page.
For example, take two stocks, MNKY and FAHN, both trading at $100. If the MNKY December 95 put has a 70% probability of expiring worthless, and the FAHN December 90 put also has a 70% probability of expiring worthless, that’s an indication that the IV of the FAHN options is higher than the IV of the MNKY options. That’s because a higher volatility implies a larger potential percentage-price change in the stock price. And the more likely the the chance a stock will make a large move, the higher the probability a further OTM strike might be in the money at expiration. (Keep in mind that probability is theoretical and isn’t a guarantee of future performance.)
With a higher volatility, FAHN is more likely to rise or fall $10 points than MNKY. And the market suggests that the price of MNKY may fluctuate less. So, the strike prices that are closer to the current stock price of MNKY may have a higher probability of expiring worthless. In this way, the volatility of different stocks translates itself into a probability. They both represent the market’s estimate of how large the magnitude of the potential price changes might be in a particular stock. Because the market determines the IV, which drives the probability calculations, they are accurate inasmuch as the volatility is accurate for the stock.
In and of itself, the volatility number of a stock, or even the market, doesn’t tell the whole story. It needs to be viewed through the practical trading lenses of capital requirements, comparison, and probability. Being able to do that, coupled with measuring how high or low volatility is relative to where it’s been, may help you determine both a volatility that presents potential opportunity, and a strategy that includes that volatility for your outlook on a stock.
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