Trading the Volatility. Part 1

One of the concepts most used, and perhaps less understood, in the world of trading is the volatility, that is, the degree of variation of the price of a stock in time, in both direction and speed. This variation is directly proportional to the risk. This makes a volatile stock more attractive for trade it (for short-term or swing traders in particular), but also riskier. Knowing how to use volatility in favor of obtaining benefits is one of the arts of stock trading.

Options and Implied Volatility

Known and used by all traders, the options are the best financial instrument to make money investing a fraction of the capital that we would use in stock as such. They are the right, not the obligation, to buy (option: call) or sell (option: put) an asset at a specific price within a specified date, through the paid of a premium. That is, the options involve price and time, the two variables that define volatility, which make it, its main protagonist. (Please refer to Bill Johnson's book "Options Trading 101: from Theory to Application" for a complete understand of the world of options. I believe it has the best explanation: clear, and avoiding some complex terms for later studies). So, thanks Investopedia, let see at a glance, the main characteristics of this incredible financial instrument, from the concept of implied volatility, the basis of the option-pricing equation.

- Option premiums (its current price) have two components: intrinsic and time value.
- Intrinsic value is an option's inherent value. The only factor that influences an option's intrinsic value is the underlying stock's price versus the option's strike price. No other factor can influence an option's intrinsic value.
- Extrinsic value (time value) is the additional premium that is priced into an option, which represents the amount of time left until expiration. The price of time is influenced by various factors, such as time until expiration, stock price, strike price, and mainly the implied volatility.
- Implied volatility affects directly price options, and represents the expected volatility of a stock over the life of the option. As expectations change, option premiums react appropriately.
- Implied volatility is directly influenced by the supply and demand of the underlying options and by the market's expectation of the share price's direction. As expectations rise, or as the demand for an option increases, implied volatility will rise. So, options that have high levels of implied volatility will result in high-priced option premiums.
- Conversely, as the market's expectations decrease or demand for an option diminishes, implied volatility will decrease. Options containing lower levels of implied volatility will result in cheaper option prices. 

- So, a change in implied volatility for the worse can create losses, however, you are right about the stock's direction. That's why options are very difficult for traders: you need to know not only direction but speed.
- Each listed option has a unique sensitivity to implied volatility changes. For example, short-dated options will be less sensitive to implied volatility, while long-dated options will be more sensitive. This is based on the fact that long-dated options have more time value priced into them, while short-dated options have less.

- The "Greeks" (Delta, Theta, Vega, and Gamma), a set of risk measures, help to value this sensitivity, or exposition, of the option to time decay, implied volatility, price. Its use is ideal for analyzing more complex option spreads as calendars, verticals, straddles, butterflies or iron condors.
- Each strike price will also respond differently to implied volatility changes. Options with strike prices that are at the money ATM are most sensitive to implied volatility changes, while options that are further in the money ITM or out of the money OTM will be less sensitive to implied volatility changes.

- Implied volatility fluctuates the same way prices do. Implied volatility is expressed in percentage terms and is relative to the underlying stock and how volatile it is. So, each stock volatility should not be compared to another stock volatility range.
- Implied volatility moves in cycles: high-volatility periods are followed by low-volatility periods, and vice versa. If you can see in its chart where the relative highs are, you might forecast a future drop in implied volatility or at least a reversion to the mean. Similar to its relative lows.- In the process of selecting option strategies, expiration months or strike prices, you should gauge the impact that implied volatility has on these trading decisions to make better choices. This knowledge can help you avoid buying overpriced options and avoid selling underpriced ones. In fact, to be profitable, you need to be aware of the amount of implied volatility (IV) that each option traded carries.

This useful chart shows the suggested trade (buy or sell) for options (calls, puts, and spreads) according to its implied volatility (low, neutral or high), and the market direction (bear, neutral or bull). Use only as a reference, the theory is more complex than this.

Determining if the IV of your stock is High or Low

In order to evaluate the implied volatility and considered at a high, medium or low level, traders should take into consideration some aspects:

- Overall Market Analysis:
Analyze the VIX index to have a big picture of the implied volatility of the market as a whole. The "fear index" gauges the market's expectation over the next 30 days, and trends exactly the reverse of the SP500 SPX. A high VIX means a high volatile market, and so, a rise in the options' price. Compare this value with the IV of your particular stock, to consider it higher or lower than the VIX value.

- Implied Volatility of the Underlying Security Traded:
Compare the current IV to the past IV over a period of a year, to identify if it's in a relatively high or low range to the past. If IV is high, try to understand the reason: news, earnings, acquisition rumors, other events. Keep in mind that after the event occurs, the IV collapse and always reverse to the mean when it reaches extreme highs or lows. So, when you see options trading with high IV, or higher than typical, consider selling strategies. The opposite for lows IV.

- Relation between Implied and Historical Volatility:
Historical volatility (HV) is the volatility experienced by the underlying stock. So, in contrast to HV which looks at actual asset prices in the past, the IV looks ahead. Compare these two indicators over a period of a year, and in the same chart. There are three possible scenarios:

IV > HV: options may be regarded as relatively expensive and it's convenient to sell.

IV < HV: options may be regarded as relatively cheap and it's convenient to buy.

IV = HV: options are not so expensive and not too cheap. You may either buy or sell options.

Finally, and no less important, traders need to complete its analysis comparing HV at this time with HV in the recent past. The HV chart can indicate whether current stock volatility is more or less than typically is. If current HV is higher than typical in the past, the stock is now "more volatile than normal". If the IV is low that didn't match this higher-than-normal volatility, the trader can capitalize on the disparity by buying options price cheap. Same on the contrary case.

- The Implied Volatility Range
It's about to identify the IV trend, up or down, and its turning points. Usually can be considered cheap options those that are traded at the low of their IV range, priced at less than the volatility of the underlying. On the other side, can be considered expensive options those that are traded at the high of their range, priced at more than the volatility of the underlying security.

- The Effect of Time Decay
Generally, the value of IV become higher as options approach to expiration, its percentage change more quickly due to an increased degree of uncertainty. The fact is that this is directly related to the amount of time left on the option. So, the IV has a stronger impact on the price on long-term options due to the higher amount of time value left till expiration.

Knowing these basics of options and volatility, in the next "Trader Notes" I will analyze some ideas on how to trade the VIX indicator and play the market in these months of high volatility (VIX >20% is considered a volatile market).

Disney's price is shown with its implied and historical volatility in a chart below, for a better comparison. As you see, today its IV=26.12% and HV=33.05%. The first thing I check is that its value is greater than the market VIX, currently at 22%, which is logical considering that DIS is a "value stock", which tend to have lower volatility than "growth stocks".
Its implied volatility reached highs in late December and then, as expected, reverse to the mean, and now is almost at its 50%, so it may be regarded as neutral. Finally, as its HV is higher than typical in the past, the stock is now "more volatile than normal". As its IV didn't match this, and also is in a downtrend toward lows, we have here a signal that its options are relatively cheap.