Trading Options in Turbulent Markets: Master Uncertainty through Active Volatility Management

Chapter 3. Working with Volatility to Make Investment Decisions

The subject of volatility, as any experienced trader will attest, is itself a volatile subject. Volatility has undergone remarkable changes during the past couple of decades in terms of how it's calculated, predicted, and utilized by investors and traders alike.

In the financial markets, volatility refers to the likelihood that securities or indexes change in value over time, either measured as a series of past events or implied for the future. Usually, the term is applied to stocks and to the options contracts based on those stocks. The share price for a volatile stock will tend to go up and down a lot over time. Traders seek to predict the future volatility of a stock or options contract based on a wide variety of factors. The volatility that a stock price has shown over time is called the historical volatility. The projected, or estimated, volatility for share prices or options contract prices for a future time period—say, the next two weeks or thirty days—is called the implied volatility.

On Predicting the Future

For options traders, successfully predicting implied volatility for contracts is crucial. But that expectation leads to a central problem related to performance for options traders, and traders in general, over the years—traders are obliged to be prophets. The most obvious issue, of course, is the dress code. Goat-hair robes, oak staves, and waist-length beards tend to interfere with trading, especially floor ...