Volatility is price variance. In finance, it is the degree of variation of a trading price series over time, usually measured by the standard deviation of logarithmic returns. Standard deviation measures the amount of variation or dispersion of a set of values. A low standard deviation indicates the values tend to be close to the mean or average, and a high standard deviation means values are spread over a wider range.
Meanwhile, logarithmic returns assume returns are compounded continuously instead of across sub-periods. In finance, there are two types of volatility, historical and implied. Historical volatility measures the price variance of a set of past prices. Implied volatility is the market’s perception of what price variance will be in the future.
Historical volatility is a tool
- Historical volatility tells us about the past.
- Historical volatility is 100% objective.
- The past can be a guide for the future.
- Past performance does not guarantee future results.
Implied volatility is a defensive weapon
- Implied volatility tells us the market’s perception of future price variance.
- Implied volatility changes with market conditions.
- Implied volatility is a crystal ball that allows market participants to see far past current prices.
- Implied volatility reflects current sentiment.
Option prices are real-time indicators of implied volatility
- The primary determinant of put and call option prices is implied volatility.
- An option pricing model can extract implied volatility from any option price.
- Option prices are constantly changing as implied volatility is a real-time sentiment indicator.
A simply at-the-money straddle is a valuable barometer
- An at-the-money straddle is a put and call option with the strike prices at the same level at the current market price.
- An at-the-money straddle tells us the market’s expected range for an asset.
- Deducting the straddle price from the current market price provides the market’s current expectation of the low end of the trading range until expiration.
- Adding the straddle price to the current market price provides the market’s current expectations of the high end of the trading range until expiration.
- The straddle is a barometer of market sentiment. When it rises, the market expects a wider range. When it declines, it expects a narrower range.
The VIX index is the stock market’s barometer
- The VIX index reflects the current implied volatility level of stocks in the S&P 500 index.
- The S&P 500 index is the most representative US stock market index.
- The VIX tells us the market’s current price variance sentiment.
- The VIX tends to rise during price corrections and fall during price rises.
Market participants must use all the tools at their disposal
- Markets often take the stairs higher and an elevator to the downside.
- Implied volatility typically rises during corrections and falls during rallies.
- Options are price insurance.
- The demand for insurance increases during corrections.
- Implied volatility is a tool available to all market participants.
- Understanding and monitoring implied volatility only increases the odds of successful trading and investing.
Thanks for reading, and stay tuned for the next edition of the Tradier Rundown!