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Options trading: Confusion about the Meaning of Volatility

By  Jun 27, 2012

Topics: Finance & Investing

So many traders are confused when they hear about "volatility." Why? Because there are so many different meanings of the word, five to be precise. Understanding the differences helps to manage options trading.

1. Historical volatility is a measurement of stock price movement in recent trading sessions, often studied using moving averages as long as 200 periods. Because it is historical, it provides no certainly about future movement; but it does give you a good idea of how stable or erratic the price pattern has been.

2. Fundamental volatility is a type of often do not hear about. It describes the predictability (or lack of predictability) in fundamental indicators, especially revenues and earnings. Is the long-term trend consistent and predictable? Or are the numbers all over the place? The degree of fundamental volatility affects your ability to identify value investments, and also affects option volatility.

3. Future volatility is a very uncertain estimate. It is intended to identify option values and volatility likely to occur in the near future. Some use future volatility to estimate option premium direction, but this is a very uncertain process.

4. Expected volatility is similar to future volatility, and is used to estimate where option premium is likely to move. It's affected by proximity between underlying price and strike; and by time remaining until expiration.

5. Implied volatility is also known as extrinsic value. It is the third version of value (after intrinsic and time value) and the only option value with uncertainty. This often can be expressed using the Greeks, notably delta and gamma to measure how IV relates to historical volatility.

The whole study of volatility is complex and frustrating. One helpful tool is a free calculator provided by CBOE. Go to www.cboe.com and link to "tools" and from there to "options calculator.