One of my favorite words in the English language is volatility. Volatility, volatility, VOLATILITY! Love it! Why? Because that is where option traders get their edge.
But, wait a minute! Why is it that the taking heads on the news talk about volatility like it’s a bad word? Two reasons: 1) They are generally speaking to the conservatively investing public who just wants to see steady growth over the next 20 years (not the kind of thing that does an active trader much good), and 2) They are talking about a different context of the word volatility than an option trader would.
When non-option traders think of the word volatility, they think of the magnitude of price swings in a stock. That is the type of volatility that option traders call historical volatility. But the volatility that option traders care more about is implied volatility. Implied volatility is, effectively, the measure of how cheap or expensive options are.
When experienced option traders buy options, they prefer buy them when implied volatility is cheap. When they sell options, they like to sell them when implied volatility is expensive. This can give them an edge over novice traders who aren’t experienced with analyzing option prices. Though options may make or lose money as the underlying changes or time passes, buying them relatively cheaply (or selling them if they seem expensive) in terms of their implied volatility provides an advantage. Putting on an option trade for a volatility edge is like taking a lead off in baseball—it’s a little head start that can help each and every trade.
I’ll talk more about implied volatility and edge in future blog posts. Stay tuned!