Historical Volatility

By Author: Anthony Green
Total Articles: 36
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Volatility to an options trader is defined as one standard deviation of daily price change in one year. It is expressed as a percent. Volatility is the most subjective variable of the fiveor six inputs necessary to calculate a theoretical price for an option. The two forms of volatility are historical and implied.

Historical volatility

Volatility that can be calculated over any number of trading days

Implied volatility

Volatility that the market place is imputing into the underlying future, given the current price of the option. The 21 percent implied volatility that existed on November 16 suggests that the S&P can be expected to remain within a range of 21 percent plus or minus its current price at the end of a year with about 67 percent confidence; or that prices will remain within a two standard deviation range with 95 percent confidence. The 21 percent implied volatility seems reasonable with respect to the most recent band of 20 to 28 percent in which implied volatility has been moving. When the implied volatility of 21 percent is compared to the historical 20-day volatility of 161/2 percent, ...
... the options appear overpriced.

The market place obviously does not expect the S&P 500 Index to be as quiet as it has been. Volatility does not have a major impact for directionally biased vertical spreaders. Therefore the 21 percent implied volatility reading for the at-the money S&P 500 futures options does not force a trader into a particular spread strictly for volatility reasons.

Upside Breakout: Remove One-Half of Losing Leg

An upside breakout from the larger Head & Shoulders Bottom on the Dec S&P 500 chart occurred on Friday, November 30. Volume expanded to 72,396 contracts, confirming the validity of the breakout. The minimum upside measuring objective is 354.25. Aggressive traders should remove one-half of the losing leg of the vertical spreads. This entails buying back 50 percent of the call options that were previously sold short. The long 320 versus short 325 Dec S&P 500 call spread will continue to be used as the example. If a pullback (prices decline) to the larger neckline occurs, the remaining (one-half) short call position should be covered. This would leave the trader in the most bullish options condition long calls. Note that the strategy matrix states that the ideal technical situation for a long call position is en route to price pattern measuring objective after pullback has occurred.

Risk/Reward Parameters of New Position

After every modification of an options strategy, the trader must be aware of the new profit or loss characteristics. A simple method of constructing the risk/reward graph involves creating a profit/loss. Using a spreadsheet format, a trader lists the individual present positions and the costs involved in getting there in Column A. Possible values at expiration (both above and below the spread strike prices) head the remaining columns. Each cell entry is calculated and the resulting outcome is tabulated in the bottom row.

Graph paper of similar scale to the chart of the underlying should be used to plot the possible outcomes.It is obvious that this new position of long more calls than short is much more aggressively bullish than the original position. Above the upper 325 strike, the options position acts (at expiration) like a long S&P 500 futures contract.