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Basics of Volatility

In the simplest terms possible, volatility is the measure for variation of price over time. The more volatile a stock is, the more it’s unpredictable and changing rapidly. Volatility trading is used when you start trading based on the volatility of a stock instead of the price itself. Any stock who’s price moves a lot can expect more volatility in the future, and the act of volatility trading is buying and selling based on that future expectation. Instead of predicting whether a stock will go up or down, trading with volatility focuses on whether s tock will move greatly in either direction.

The most common way to volatility trade is to use options. Options provide a simple way to gain exposure to the volatility of the stock. Options on an equity index with a high-expected volatility are more valuable than options on a less volatile stock.

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Three types of volatility

There are three main types of volatility, historical volatility also known as realized volatility, relative volatility and implied volatility. Volatility is expressed in annual terms and Historical Volatility or HV is to measure the volatility of a stock based on its history. For example HV(30) means a 30 day historical volatility and its based on the daily gain or loss in the last 30 days of trading.

Relative volatility is sometimes measured by the mathematical term for a correlation coefficient between two prices, or Beta. The Beta value of a stock is figured out by looking at the market as a whole. A beta value of greater than 1 means it moves more than the market, whereas less than 1 means it moves less than the overall market. Negative values means that the stock generally falls when the market rises, and positive means it rises when the market falls. This volatility is measured relative to the market.

Implied Volatility or IV is not calculated by the history of a stock or the stock relative to the market but by the expectation of future movement. IV is the expectation of the volatility of the stock between the present time and the time of the options expiration.

Nowadays most volatility is calculated by software tools but in the old days it was calculated by using an excel spreadsheet with a bunch of numbers. Low volatility would promote straight options buying and high volatility is a great time to sell. This is just an example however and not a definite thing.

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Understanding volatility

It’s common for inexperienced traders to overlook volatility when an option position is established. This is usually because they just don’t understand it and it may take some time to get used to the terms. It’s important to try to understand volatility so you can start trading without the risk of loss. Proper understanding of this concept will lead to many profit potential options and make for a much better trader.

When you understand volatility you will be able to predict big price moves easier and profit greatly from these market changes. This is a key concept for beginners to get their head around and its important to have at least a basic understanding. Buyers of options will always manage to benefit from increased volatility so it pays greatly to know when it’s happening and how to find it. In general the higher the implied volatility is the higher the option price will be.

When you understand option volatility it will alloy you to figure out whether options are cheap or expensive by comparing implied volatility (IV) to historical volatility (HV). Implied volatility is simply an estimate of the future of a stock, and historical volatility is calculated by measuring the stocks past price movements and is figured out based on past data. The data is readily available to you and in general stocks with high levels of historical volatility have had large price swings in the past. To fully understand this will give a beginner trader many opportunities for profiting on the stock market.

One Response to “Basics of Volatility”

  1. elle duncan says:

    What’s up colleagues, good paragraph and pleasant
    urging commented here, I am really enjoying by these.

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