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More about Volatility - Options Mastery Series Lesson 4

Filed Under Options Mastery Series 

Options University’s founder Ron Ianieri states in one of his Options Mastery Course: “As traders, we have to be able to determine for ourselves what the relative highs and lows for different stocks are going to be because obviously we don’t want to be buying an option that’s very high in terms of its volatility relative to what the stock normally trades at; nor do we want to be selling options when the range is very low. So we have to get an idea for ourselves of what the volatility ranges and measurements are”.
 
Measures of volatility are relative. For example a high volatility might be 30 while others might be high with a 90. High or low volatility is relative to the particular underlying stock. To derive what is high or low, we need to know what the mean or average for the particular underlying stock volatility is. To get the best idea of what monthly volatility is, we will look at the at-the-money strike price because it has the most attention and it’s the most accurately priced, but the second thing is it also has is the highest sensitivity to movements in volatility.
 
When we talk about measurements we talk about how we’re going to gauge whether present implied volatility is high or low. We do that by establishing a base volatility. The pros use a Volatility Cone-or Volcone Analyzer- to help measure historical volatility. Once a base volatility is determined, a comparative high or low volatility measure can be produced by establishing standard deviations based on the data. For example, if   a current variance of implied volatility is over one standard deviation to the right that means that the current implied volatility is outside of the normal 68% expected range and is statistically “significant” to the upside.
 
Volatility Skew
Different options of different stocks trade at different volatilities from month to month and strike to strike. Even two options that are corresponding options (same strike and same month) have a call and its put that trade at two different volatilities. When this happens, it’s called “skew”, and in the real world of option trading there are many volatility skews.
 
The “vertical skew” (also called the volatility “smile”) demonstrates that as the strikes in the same month move away from the at-the-money strike (both into and out-of-the-money), volatility increases. Volatility is normally the lowest at-the-money. If you chart the volatilities, it resembles a smile with the low point at-the-money. Moreover, front months display a bigger smile, while the outer months seem to produce lesser smiles. 
 
The “horizontal skew” (also called “tilt”) looks at what is happening to the same strike over different months. Same strike prices usually trade higher in the front month’s and decrease the further out you go. If the reverse happens, that is called a tilt inversion. This knowledge can become valuable when trading time spreads.
 

The last skew we’ll talk about today is the “put-call skew”. Theoretically, same month, same strike calls and puts should trade at the same price. However, in the real world, often the call price is trading higher than the corresponding put (positive skew). Likewise, put prices may be trading higher than the corresponding call (negative skew). Both of these situations can be important considerations when using different stock option strategies.

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