Any financial dictionary defines volatility as “a measure for variation of price of a financial instrument over a period of time.” A trader can look at historical volatility through many different timeframes: 10 days, 100 days, 1 year, or even 5 years. I'd like to take this definition one step further by saying that implied volatility, when looked at through the lens of options prices, is a measure of how much the market is expecting the underlying stock to move in either direction within a certain timeframe. In this chapter I discuss how historical and implied volatility affect options prices.
Volatility is a very important part of options trading, so it is essential to cover it in depth. This is because small changes in the implied volatility can significantly impact the option's price. Volatility is a key component to understand because a trader can make or lose money on an options trade even if the stock does not move.
Here is the interview question that a seasoned trader would ask a potential trader:
XYZ is trading $100 and I am long the XYZ $100 straddle for $10. If one week passes and the stock has not moved at all in that week, how much would the straddle would be worth? Is it possible that I could have made money on my trade?
Most would say “No, the straddle should have decayed in value. That is true, but if the implied volatility had gone from 20 to 40 on a possible ...