Understand Volatility in the Derivatives Markets while Day Trading - dummies

Understand Volatility in the Derivatives Markets while Day Trading

Day traders seek more volatile securities because they offer more opportunities to make money during any given day. For this reason, they need to have ways to minimize the damage that may occur while being able to capitalize on the upward swings.

Expected return from day trading gives you an idea of how much you can get from a trade on average, but it doesn’t tell you how much that return may vary from trade to trade. The average of 9, 10, and 11 is 10; the average of –90, 10, and 110 is also 10. The first number series is a lot narrower than the second. The wider the range of returns that a strategy has, the more volatile it is.

You can measure volatility in several ways. One common measurement is standard deviation, which tells you how much your actual return is likely to differ from what you expect to get. The higher the standard deviation, the more volatile, and riskier, the strategy.

In the derivatives markets, volatility is measured by a group of numbers known as the Greeks: delta, gamma, vega, and theta. These numbers are based on calculus. Don’t worry if you forgot it or never took it!

  • Delta is a ratio that tells you how much the option or future changes in price when the underlying security or market index changes in price. Delta changes over time.

  • Gamma is the rate of change on delta. A derivative’s delta will be higher when it is close to the expiration date, for example, than when the expiration date is further away.

  • Vega is the amount that the derivative would change in price if the underlying security became 1 percent more volatile.

  • Theta is the amount that a derivative’s price declines as it gets closer to the day of expiration.