As you begin to trade options you will discover that some markets are a little more trader friendly than other markets are. By trader friendly, I mean that they give you an opportunity to profit. One the big factors in whether a market might be profitable if volatility.
Very simply put, volatility is the degree of fluctuation in the stock price of futures contract of an underlying security. If the underlying security is prone to wide swing in price then its volatility will be greater than an option whose underlying security is fairly stable in price.
There are two different types of volatility: historical and implied. Historical volatility, as its name implies, is calculated using historical prices. Traders will look at historical volatility to determine what type of strategy that they should use when trading this market. Although you often hear the phrase “past performance in not indicative of future results” in financial circles, the concept of historical volatility is based on the past predicting the future. A market that has been volatile in the past will tend to stay volatile.
Implied volatility is the volatility that is based on the Black-Scholes pricing model (stocks) or the Black option pricing model (futures). If your option price has increased in value but the underlying security has not changed in value then you know that your implied volatility has increased. This will occur if there is a perception that the underlying asset will make a larger than normal move in price in the near future. Now this perception might be wrong and because of this many traders will look for changes in implied volatility to use specific option trading strategies.
If volatility has driven option prices higher than traders believe they should be then they may be a seller of the volatility. If you are selling covered calls this may be the opportunity for get the most premium.
Together these two volatility measures can be one of your best options trading weapons. If you can understand volatility and how it affects pricing it can go a long way to making you a more profitable option trader.