Tradier Rundown

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!

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