Watching Volatility When You Trade Options - dummies

Watching Volatility When You Trade Options

When trading options, you want to be able to predict when changes in volatility — and thus changes in prices — are coming. One way to do that is to keep tabs on historical volatility (HV).

You can chart 10-, 20-, 50-, and 100-day volatility figures. Watch the trends during each of the four periods. If the 100-day volatility was 60 percent and the 10-day volatility was 10 percent, the volatility in price of the underlying asset is slowing. When prices begin to congregate in narrower trading ranges, volatility begins to decrease, and it can be a sign that a big move is coming. That’s when you can

  • Start paying closer attention to the option series and making potential trading plans.

  • Decide whether implied volatility (IV) is cheap or expensive, no matter what you may think the prospects of the underlying asset are.

  • Play the momentum, which is also a good strategy with options, regardless of volatility. A couple of simple but powerful algorithms are buying calls or selling puts in stocks currently trending higher, or buying puts and selling calls in markets currently trending lower. In other words, paying attention to strong price trends can outweigh all volatility considerations.

When the majority of traders expect the underlying asset to be nonvolatile, as indicated by low volatility measurements, or wide spreads between HV and IV appear, you need to be buying volatility.

That means when everyone else is selling options, you need to analyze the situation and pick the options with the best potential to buy, always knowing that you can be wrong and making plans to get out of the positions before you lose a whole lot of money.