Wednesday, March 4, 2009

Trading Lab Recap - Volatility

In tonight’s trading lab Historical and Implied Volatility were the topics of discussion:
Statistical or Historical Volatility (HV) as defined by Investopedia:

“ The realized volatility of a financial instrument over a given time period. Generally, this measure is calculated by determining the average deviation from the average price of a financial instrument in the given time period. Standard deviation is the most common but not the only way to calculate historical volatility. ”

Historical Volatility is the equivalent of looking in the rear view mirror at the past price action of a stock.
Stocks with High HV tend to have a lot more movement in their price
Stocks with Low HV tend to have a small amount of movement in their price

One important caveat to Historical Volatility:
Large gaps (due to news events, such as an earnings announcement) can skew the Historical Volatility to look as if the stock is way more volatile than it usually is. For example PSYS has a 20 HV of 186. This high 20 HV is due in part to the enormous gap that occurred within the last 20 days. As soon as the gap day drops out of the equation, the HV will drop significantly
Other Indicators that measure a stock’s volatility:
Bollinger Bands
ATR (Average True Range)

Implied Volatility
The amount of future volatility expected in the market (derived from current option premiums)
The level of volatility the underlying needs to exhibit to justify current option premiums.
HV is backward looking, IV is forward looking

Generalizations about volatility:
Implied Volatility is mean reverting (it oscillates around its mean or average)
When IV is high, options are relatively expensive and potentially overpriced (I'd rather be an option seller)
When IV is low, options are relatively cheap and potentially underpriced (I'd rather be an option buyer)

The following patterns often occur at market bottoms:
Slowing Momentum
Double Bottom/ Triple Bottom
Reverse Head & Shoulders

Target for long stock trade:
Sell at 1 ATR profit
Sell at resistance
Sell at projected target:
"If in doubt, scale out!"


Rene said...

Hi Tyler -
How do you determine if IV is high and therefore driving up the option premium? I'm trying to get a handle on when I should be an option buyer versus and option seller. Thank you!

Tyler said...

Rene - Great question. I've been swamped the last few days so sorry it's taken awhile to answer your question. There are two methods commonly used by traders in assessing IV.
Method I is to assess where IV is currently at relative to its historical range. When IV is at the upper end of the range, then options are relatively expensive and potentially overpriced. If IV is at the lower range, then options are relatively cheap & potentially underpriced. You can look at volatility charts to assess the range using the website
There are flaws to this method. It assumes volatility always reverts back to its mean (average). Unfortunately that doesn't always happen (Fall 2008- when $VIX skyrocketed).
Method 2 is comparing IV to HIstorical Volatility. If IV is a lot higher than HV, than options are potentially overpriced, if IV is lower than HV, than they are potentially underpriced. Keep in mind there are also flaws to this method as well...