Learning how to trade volatility is a major concept for new traders to learn when starting out in options trading. Implied volatility is one of the most important pricing inputs in the Black Scholes option pricing model and while I will not detail all the calculations now, it is built on various inputs, of which implied volatility is the more subjective (as future volatility isn’t known, we have to make a best guess) and therefore, gives us the greatest chance to manipulate the pricing model based on our view of volatility compared to that of other traders. One of the arrow keys to learning how to trade volatility is learning how changes in implied volatility will affect the different option trading strategies. While, you do not need to master all the advanced topics on volatility (and there are plenty), a good basic understanding will go a long way in helping you become successful.
Option volatility incorporates any events that are known to occur during the life of the option that might affect the motion of the underlying stock. Example can be an earnings release or the outcome of a drug trial for a pharmaceutical conglomerate. The mood of the general market is also contained in volatility estimates for individual stocks. If markets are subdued, volatility estimates are small, but when markets undergo corrections or violent moves, volatility estimates will be hiked. An easy method of watching the general levels of market volatility is to oversee the VIX Index, ticker symbol VIX. This will tell you how market participants view the current levels of volatility.
Bands will be narrow when the volatility in the market is low. These bands expand when the volatility in the market increases. This information can be particularly useful to options traders as options prices are strongly influenced by the swings in volatility.
Average daily trading volume in the S&P 500 index has fallen every year since the crisis, and in 2013, it’s now at levels not seen in 15 years. On the other hand, the use of options to trade the S&P 500 has taken off over the past ten years, and in 2013, it’s near all-time highs. With more and more investors expressing their views on stocks via options as opposed to trading in actual shares, it’s interesting to take a look …
For anyone looking to get started in options trading, I strongly recommend you learn about option implied volatility and at least gain a basic knowledge of how to trade volatility.