Volatility in Options

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What is Volatility?

Volatility (often referred to as vol) is a very important factor when talking about options. Clients often neglect this component which can affect pricing immensely and could be the difference between profit and loss with a position. 

Put simply, volatility measures the risk of an asset and its ability to swing around its mean price. Volatility is a rate at which the price increases or decreases for a given set of times. If the prices of an asset fluctuate rapidly in a short amount of time, then it is said to have high volatility. If the price of an asset fluctuates by only a small amount over a longer period of time then it is said to have low volatility.  

Volatility is used in option pricing formulas to work out the fluctuations in the returns of the underlying assets. Therefore volatile assets are often considered riskier than less volatile ones as their price is less predictable from a market makers point of view meaning the volatile asset options will be more expensive as the buyer may have greater trading opportunity.

Volatility itself can be broken down into two parts: Historical Volatility, which is often referred to as statistical or realised volatility; and Implied Volatility.

Historical Volatility

Historical volatility is the standard deviation of historical returns of an asset over a set period of time. The important thing to remember is that this is historical. When historical volatility rises, a security’s price will also move more than normal, meaning that there is an expectation that something has or may change. If historical volatility starts to drop, it means any uncertainty has dissipated.

Implied volatility

Implied volatility is the figure which captures the market’s forecast of a likely change in a given price. It shows you the volatility implied by options of a particular security and uses supply/demand, time value and whether we are in a bearish or bullish market to calculate. Simply put it allows traders to see how volatile a market may be going forward.

Important information: Derivative products are considerably higher risk and more complex than more conventional investments, come with a high risk of losing money rapidly due to leverage and are not, therefore, suitable for everyone. Our website offers information about trading in derivative products, but not personal advice. If you’re not sure whether trading in derivative products is right for you, you should contact an independent financial adviser. For more information, please read our Important Derivative Product Trading Notes.

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