Financial markets purely embody the actions of buyers and sellers expressing their opinion on the path of least resistance of prices with their...
The Hidden Value of Implied Volatility
Implied volatility is a crystal ball that allows market participants to see far past current prices.
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!