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Be Prepared — With a Complete Picture of Volatility



Most people know the Scout’s motto: “Be Prepared”.

This isn’t just good advice for impressionable young men; it’s a great way to face most tasks in life. Trading options is no exception. I always examine three things before making any trade: implied volatility, historical volatility and the direction of volatility. Being a successful option trader requires being able to see the big picture — which involves relating option pricing levels to historical volatility.

Let me use an analogy: Insurance premiums are generally tied to underlying risk. Let’s assume that a $1 million house in Toronto costs $1,000 to insure and that an exact duplicate $1 million home near the coast in Florida costs $2,000 to insure. Both houses have the same value, so why does one house cost twice as much to protect? Since the home in Florida carries a higher risk of sustaining damage from a hurricane or similar threat, the insurance company needs to charge an appropriately higher fee. In part, the insurance company determines premium pricing by looking at past home damage data in the region. In other words, it is looking at historical volatility in order to effectively price implied volatility.

Option traders should use appropriate software to analyze where implied and historical volatility are trading — both on an absolute and relative basis. An example would be Before making an option trade, look at a chart of implied volatility to see where options of a certain duration have been priced. You need to consider if option prices are high or low based on the past year’s range. Then, overlap that chart with a chart of historical volatility in order to relate current option pricing to past risk.

For option traders, risk isn’t home damage, it is stock movement. In the same way that the insurance company is assessing past risk of home damage, you need to look at historical stock movement to determine how you feel about where current options are priced. Are options priced higher or lower relative to how the stock is moving?

Finally, I like to assess the direction of volatility. You may discover that options are currently more expensive than historical volatility. But what if historical volatility is rising steadily? Do I want to sell straddles and strangles into a market that is moving in an increasingly wider range? Probably not. Instead, I would wait for historical volatility to taper off, and give myself a better signal that the market is calming down.

Why are these things critical to consider? I’m a private pilot and I would never set off on a trip without looking at the weather and winds. I chart my route and go through my checklists. Assessing implied and historical volatility is just that — checking the climate. It’s seeing if the weather is getting worse or getting better. It’s looking at checklists to ensure that I have a complete picture of volatility before putting my hard-earned capital to work. Without following a similar process, you just might be flying blind.


Source: Bloomberg, as at September 30, 2016.

The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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