A good understanding of volatility is important to option trading. A misunderstanding of this topic could leave a trader with losses and frustration as to why their trades that and go as planned. In this article, I am going to discuss the two primary types of volatility that an options trader may want to consider before placing their trade.
There are two types of volatility that should be considered before placing an option trade. The first type is called implied volatility and is more closely tied to the options price. The second type is called statistical volatility and is more closely tied to the price of the underlying security.
Statistical volatility is sometimes referred to as historical volatility. It's a measure of how volatile and market is and reflects the day-to-day fluctuations of the prices for that market. So, a market with a statistical volatility of .90 will be more volatile than one with a measurement of .25.
Implied volatility is derived from an option pricing model. It's the volatility that is implied in the price of the option. If traders who are involved in option trading are expecting some future event to radically move prices of the underlying security, they may want the buyer to pay more for the option that they are selling. When this happens the implied volatility increases. However, if the option seller is not very excited about what could happen in the future, options prices may reflect very little implied volatility.
So, how is all of this useful? When options traders compare statistical and implied volatility they can determine whether or not the option's price is over or undervalued based on the difference between these two values. If the implied volatility is higher than the statistical volatility, the option's prices would be more expensive than if the option's pricing model reflected the implied volatility closer to the statistical. If the statistical volatility value is higher than the implied, it would mean that the option prices are cheap because the daily fluctuations are greater than the anticipated future price movements of the underlying security.
Some traders fine option trading very rewarding. And, a good understanding of these two topics will go a long way in the education and trading results of options trader. This is especially true if the option trader buys options or options spreads for a net debit.
Stock option trading offers the skilled trader more potential for making a fortune option trading than almost any other form of online trading in today's market. The degree of controlled risk along with superior leverage allows a knowledgeable option trader the chance to make huge profits but an aspiring option trader must have a solid foundation of education about what makes up a sound option trading method in order to have a long term success at option trading. There are five essential keys that any option trader must understand when developing a winning stock option system.
First, you must understand the degree which time affects the premium of the option you are considering trading. There are two parts you must consider when factoring time into the stock option trading decisions. The first thing that you must take into account is the intrinsic time left on an option. Since options have a limited time period of anywhere from 30 days to several year depending on the particular option that you bought you must be sure that you purchase the correct option containing enough time on it to insure that time decay doesn't erode your investment away before your position has enough time to be profitable.
The second skill of trading options profitably is factoring time into your trading system in relation to trading a particular stock option and knowing the statistics of your option trading methodology or option trading setup by knowing the average holding period of a trade signal. If your average holding time for an option trade is seven days then you don't want to buy an option with three months of time premium left on it because you would be paying more for the extra time with the option's purchase price. Nor would you buy an option with less that 30 days till expiration as time decay would erode the value of option so quickly that even if the option's underlying stock movement moved favorably to you the time decay would prevent you from realizing a gain in the option itself.
The third thing to profitable stock option trading is understanding the relation of volatility between the market, the underlying stock that underlies the stock option, and the effect is has on the value of the option itself. When the general stock market as an index goes thru periods of volatility or low trading ranges the stocks that make up the market tend to follow overall trend and also begin to experience periods of low overall volatility which in turn can cause derivative like stock options to become cheap or low premiums. But if the market's volatility rises it is likely that individual stocks will follow the trend causing stock option premiums to increase in value given that the market moves in the trader's favor.
The fourth key secret to trading stock options successfully is having an option trading method that combines these key secrets into a coherent method for giving clear entry signals, clear exit signals, a system of trade management, and a profit factor greater than your average loss over a given amount of trades. Understanding all the fundamental steps of various trade setups is pointless if you don't have a trading approach that leads you through every level of the trade management process. A winning stock option system guides you thru every step and details each step towards helping you become a consistent winner in the stock option markets as well as being a profitable trader in the end.
The fifth and final step to trading stock options successfully is trading psychology. Traders and there mental makeup are usually complex so it is very important that stock option traders have a sound stock option trading system or method that factors this into their overall approach to trading the markets as well as the discipline to follow their trading methods. You can give two traders the same exact profitable trading system but its very likely that they will experience very different results. The reason for this is usually is because the one that has the ability to remain as detached from his losing trades as well as his winning trades while maintaining the discipline to follow the system's rules no matter the individual trading result will come thru as the most profitable trader in the end which shows us that it comes down to a superior mental process towards trading the markets.
Using these five steps as a foundation to create your own stock option trading system can help you avoid the mistakes of many other stock and option traders. By understanding time decay, factoring an option's time into your trading method, how volatility impacts a stock option's intrinsic value, what details a winning stock option trading system, and your own trading psychology you now have a the key steps to build your trading career on.
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Sam Perdue has sinced written about articles on various topics from Options Trading. Sam Perdue has been actively trading the markets for over 13 years. He has written a computer program that helps traders analyze the stock, Forex, commodities and options markets using Fibonacci ratios,. Sam Perdue's top article generates over 4400 views. to your Favourites.