One of the most confused concepts and misrepresented concept in Stock Trading. Failing to understand and implement Statistical Volatility and Implied Volatility before placing any trade is a very gross mistake which can result in huge losses that cannot be easily repaired.
It is very vital to analyze the Statistical Volatility and Implied Volatility before entering any trade. These two values from the premises of strategy selection and also trade selection. Overlooking even one of the aspect could be the reason for loss from the very beginning.
WHAT IS VOLATILITY
Volatility is a Statistical measure of uncertainty of returns over a period of time for a given Security or Market as a whole. Volatility is usually measured with Standard Deviation. At time variance is also used to measure the volatility it can be compared to same security or the market.
The dictionary definition of volatile as it applies to financial markets is “tending to fluctuate sharply” or “tending to rapid and extreme fluctuations.”
The most important point misunderstood that volatility and price action are non-directional. When the market is showing increased volatility it does not signify any directional move in the price, but the emphasis should be given to the possible range of movement in the price of stock.
Now the above understanding is the ground fundamental of statistical volatility. Most people confuse this with INDIAVIX which leads them to take a wrong decision. Now VIX is Volatility Index which inversely proportional to the price action. When IndiaVix rises it’s definitely a concern for a bearish price action.
TYPES OF VOLATILITY
Types of Volatility will give you a better understanding of the functioning of volatility. There are totally three types of Volatility.
- Historical Volatility
- Relative Volatility
- Implied Volatility
The other names of Historical Volatility is Derived Volatility or Realized Volatility. Historical Volatility is calculated from the past price movements. Historical volatility is usually presented in annual terms. Unless and until mentioned for a specific period of time. Based on the historical price movements it defines what is the range of price movement. An increase in Historical Volatility does not imply a directional price action but increase in the range of price action. Likewise, a decrease in Historical Volatility implies a decrease in the range of price action.
Relative Volatility is Correlation Coefficient of between two price series. It is also otherwise commonly known as Beta. It is a mathematical calculation. Most of the time the value is calculated relative to the market as a whole. The beta value higher than 1 means the stock would move more than the market. At the same time, Beta value of less than -1 means the stock is negatively correlated to the market. When the market moves up the stock would move in the opposite direction and vice versa.
Implied volatility is the projected volatility of the underlying. If the volatility is historical in nature only then it would be calculated from the historical data. In the case of implied volatility, the value is derived from option pricing model. More specifically is expected future volatility of the underlying that is implied by the price of the option. What the market as a whole expects the future volatility between today and the expiration of the option is implied volatility.
The entire article has been kept very simple so that one can easily understand the difference between Implied volatility, Statistical Volatility & Relative Volatility.
Each of the 3 volatility has different uses which would be elaborated in other posts. Since it is a very big topic to cover the entire usage of volatility in a single post.
Perhaps you have been wondering why you are not getting the desired results from your Option Strategies.
Review your strategy and then go through the article again to have a better understanding. You would have made some fundamental mistakes in selecting the strategies.
If that is the case now is the right time to make necessary adjustments and save from making losses.
Nevertheless, the impact of implementing these corrections the time and other resources you spend in making these adjustments. You might not see more profit with these corrections but definitely, your capital is not going to erode.
Have you experienced this earlier? With this fundamental change have you corrected your strategy? Would you recommend this to a newbie Option Trader? Let’s hear your thoughts in the comments below!
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