There’s been a lot of talk about volatility in stocks lately.
But today, I want to focus on options volatility and what it means for the options investor.
So let’s start off with a definition:
Volatility measures the rate at which a security moves up and down. If a security is moving up and down quickly, volatility will be high. Conversely, if a security is moving up or down slowly, volatility will be low.
Options volatility is largely pinned to the underlying stock.
Traditionally, option traders look to buy options when volatility is low since premiums are lower.
And traders look to write options when volatility is high as option premiums tend to be higher.
Of course, the trick, like anything, is knowing what’s high and what’s low. If you’re buying options with low volatility, you then want to see the volatility increase. And vice versa, when writing them.
But I do want to say, volatility is only one item in determining an option trade. Putting on an option solely because of volatility would be a mistake. But understanding how volatility affects your premium is important.
Volatility can also tip you off that something big might be getting ready to happen.
When option volatility is low, there is a high probability that a big move could be getting ready to occur.
Interestingly, when volatility drops and things are kind of quiet in the market, that’s often when things heat up all of a sudden. The smart options trader will look to buy options in that environment – whether he’s bullish or bearish – by buying calls or puts.
Because in addition to the option increasing in value due to moving in the right direction, it’ll also increase in value because of the increase in volatility.
This happens because as volatility increases, there’s an increased likelihood of rapid advances and larger price swings. That also means the higher the likelihood of an option trading in-the-money by expiration, the more it’s worth to the buyer of an option.