Friday, March 19, 2010

Volatility - Part II

In the last post we discussed Historical and Implied Volatility.  It's time now to see how these two important indicators can be used to help increase our probabilities of a successful trade.

For this discussion, we are going to treat HV and IV as the surrogate projection of the stock and option price respectively.  We are also going to use a website that is well known for volatility information -

 After going into and entering the underlying symbol of the stock, two choices of graphs appear on the right hand side and the bottom graph is the Volatility graph.  The blue line is the 30 Day HV and the yellow line is the IV.  We read the chart on the right and it becomes important to understand where the lines should be to be in a "sweet spot" for various trading strategies.

If, for example, the IV is at 68%, we read this as that the Option is priced for a 68% move, up or down, in the underlying stock.

Now, we look at the position of the HV and IV on the right hand side of the chart.  The following graphic illustrates how for a Call Option, the HV should be below the mid-point and the IV should be below the midpoint.  If the stock is undervalued, then the probabilities of it going up are greater, and if the option is undervalued, then the price is right for the Call Option that is purchased.

So, in this particular chart, volatility is acceptable for a Call Option.  In the next post, we will look at the volatility requirements for both the Put Option and the Covered Call.