Volatility

Volatility is often used to describe events, people, and feelings, but it can also describe markets and asset performance. For options traders, volatility is both a sentiment and a quantitative measure of price ranges for a given asset. In the Options Institute, we like to say volatility is not about where an asset’s price moved to, but rather how it arrived at that value.

Volatility is the distribution of possible price ranges for an asset based on one standard deviation from the average or current price. A bell curve is used to model the probabilities. A wider distribution or range of possible prices represents more volatility.

The Importance of Volatility

Why is volatility important? Options traders form market opinions using volatility since it provides a probable range of underlying asset prices over a certain timeframe. One trader’s opinion on an asset’s volatility may differ from another trader’s opinion. Trading volatility allows for risk transfer between its buyers and sellers who may have differing investment opinions and resources.

Remember, an options contract has several known data points: underlying spot price, strike price, time to expiration, and interest rate. Volatility is the unknown variable impacting an option’s value. It is this variable, and the difference in opinion around it, that impacts traders’ decisions to buy and sell options.

When trading options, volatility becomes a lens through which many traders consider and ultimately make trading decisions. For example, higher volatility levels mean the price of the underlying is likely to move dramatically up or down over a short period of time. Thus, higher implied volatility usually means an option will be more expensive since it has a greater chance of expiring with value. Understanding volatility can provide traders with an edge and the ability to make better trading decisions!

Types of Volatility

As we learned, volatility is a metric that an investor or trader may infer or back into. The type of volatility we calculate is determined by the method we choose.

There are three types of volatility. First, there’s historic, or realized, volatility, which uses past prices to calculate the average volatility of an asset. These prices happened already and can’t be changed; historic volatility is a backward-looking metric.

The other two types of volatility, expected and implied, are focused on the future. They are predictive and forward-looking by design. To calculate implied volatility, traders use an options pricing model, such as the Black-Scholes Model, to calculate a forward-looking expectation for volatility that is implied by quoted options prices. If we know the option’s price, we can rearrange the pricing model equation and solve for the implied volatility value. An options calculator is a commonly used tool that can help you do just this. In contrast, expected volatility does not use a pricing model directly. It uses a calculation methodology that utilizes publicly available, observable option price data to calculate a value.

Like any calculation, changes in volatility (deviations or variances) vary over time. The value calculated for volatility will likely yield a variety of results depending on the specific time frame you are using for the calculations. An asset’s price movements may seem very volatile over a one-day time frame; however, over the course of a year that asset’s price range might actually be considered low volatility if the range of price values that the asset trades within remains very narrow.

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Disclaimer: Cboe and Webull are separate and unaffiliated companies. This content is provided by Cboe and does not reflect the official policy or position of Webull. This content is for educational purposes only and is not investment advice or a recommendation or solicitation to buy or sell securities.