Volatility is a popular topic among option traders. But it can be confusing. Looking at volatility from the perspective of trading capital, past activity, and probability may help clear things up.
Option traders love to look at and discuss volatility (vol). Many option traders monitor the Cboe Volatility Index (VIX) and try to choose the appropriate options trading strategy for a given level of implied volatility (IV).
This makes sense because mechanically, vol can impact the price of an option. Implied volatility, for example, is derived from current options prices via a pricing model. So vol can definitely inform you about options prices. But they’re not the same thing. Looking at price and vol as equal can be misleading. Viewing vol through a slightly different lens could help clear up some misunderstandings and help you see how vol can be your friend when buying stocks or selling options. Volatility is a forecast that indicates the state of the market and stock at the present moment. Keep in mind, those expectations can change, sometimes very quickly.
Monster stocks with prices above $500 per share—the kind that can move $20 or more in the course of a typical trading day—attract a lot of attention. After all, a $20 move can mean a lot of money. If you own 100 shares of such a stock, that’s a $2,000 move. But is all the opportunity, or the risks, in high-priced stocks?
Nope. Those $20 moves may be impressive, but don’t confuse dollar changes with percentage changes, which is what volatility is all about. Let’s do a little math:
So 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 would’ve seen more profit (or loss) with the $50 stock because you’d control more shares.
To take this one step further, because stock price is an important variable in any options pricing model, the options prices on a higher-priced stock will be greater than the options prices on a lower-priced stock—volatility and all other things being equal. You’ll see out-of-the-money (OTM) options on a $600 stock with high premiums compared to the options on a $50 stock. But trading a high-priced option on a high-priced monster stock doesn’t necessarily mean you can make more. The capital requirement on those high-priced stocks can be a 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 on 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 one OTM put on the $600 stock.
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 trading fewer contracts, which requires less capital and lets you diversify more.
Looking at volatility from the perspective of trading capital could help you realize that you don’t necessarily have to go after big swings in high-priced stocks.
If stock XYZ’s options have an overall IV of 40%, is that high or low? It’s hard to tell without understanding the volatility range the stock has had in the past, or where it is relative to other stocks in its industry sector. Many traders monitor the VIX (which is a measure of the IV of SPX options) and compare VIX to the volatility of an individual stock. But if the VIX is 15%, does that mean that 30% volatility in a stock is high? Not necessarily. You need to compare the stock’s current IV to past IV to better judge if it’s high or low.
To help compare volatility, you can look at options statistics and charts on the thinkorswim® platform from TD Ameritrade.
Options statistics. From the Trade tab, scroll down to Today’s Options Statistics (see figure 1). The Current IV Percentile shows you today’s IV 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, and closer to 100% means vol is high relative to where it’s been.
thinkorswim charts. You can pull up an implied volatility chart to see IV on different time frames. From the Charts tab, enter a symbol. At the top right, select Studies, then Add study > All Studies > I-L > ImpVolatility from the menu. You can compare the current IV to its high and low values for short- and long-term ranges.
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Many retail traders routinely use the probability of an option expiring in the money (ITM) or OTM to choose a trading strategy. But are equal probabilities actually equal? The simple way to answer this question is to look at the Analyze or Trade tab on thinkorswim, and from the Layout menu in the Option Chain, display the Probability OTM and Probability ITM.
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 indicates the IV of the FAHN options is higher than the IV of the MNKY options. A higher volatility implies a larger potential percentage price change in the stock price. And the more likely a stock will make a large move, the higher the probability a further OTM strike might be ITM 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 into a probability representing the market’s estimate of how large the magnitude of the potential price changes might be in a particular stock.
The volatility of a stock or market doesn’t tell the whole story. Vol needs to be viewed through the practical trading lenses of capital requirements, implied volatility comparisons, and probability. This new set of lenses, along with an understanding of how high or low volatility is relative to where it’s been, may help you determine both a volatility that presents a potential trading opportunity and a strategy that aligns with the volatility of a particular stock.
Jayanthi Gopalakrishnan is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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