Options Trading Strategies – Wrong Use of Historical Volatility and Implied Volatility Crossovers

March 5, 2011 by  
Filed under Option Trading

Options Trading Strategies – Wrong Use of Historical Volatility and Implied Volatility Crossovers

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Home Page > Finance > Investing > Options Trading Strategies – Wrong Use of Historical Volatility and Implied Volatility Crossovers

Options Trading Strategies – Wrong Use of Historical Volatility and Implied Volatility Crossovers

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Posted: Jun 27, 2009 | Views: 257 |

Not all volatilities are constructed equal.   It is critical to differentiate between Historical Volatility and Implied Volatility, so retail traders learn how to trade options focused on what is material to theoretically price option spreads forward. Historical Volatility (HV) measures past price movements of the underlying asset recording the asset’s actual or realized volatility.   The more commonly known type of HV is Statistical Volatility, which computes the underlying assets return over a finite but adjustable number of days.   Let me explain what “finite but adjustable” means.   You can vary the number of days to measure the Statistical Volatility: for example, 5-10-50-200 days, that’s how time-based moving averages and momentum/oscillator studies are built.   Though, it is not the case with Implied Volatility. Implied Volatility measures expected values by repetitively refining bid-ask estimates.   These estimates are based on the expectations of buyers and sellers. The buyers and sellers (85+% of floor traded volume is driven by institutions, floor traders and market makers) behind the bid and ask values, who do change their estimates within the day, as new information be it macro-economic news or micro-economic data impacting the underlying product becomes available.   What is being estimated is the underlying asset’s future fluctuation with certain assumptions embedded into the changes in information of the underlying.   That refinement of bid-ask estimates must be completed within finite time-bound option expiration periods. That’s why there are monthly and quarterly option expiration cycles. You cannot change these expiration periods, either by shortening or lengthening the number of days, to “construct” a time period that gives you faster or slower crossover indicators. Why point out the wrong use of Historical Volatility and Implied Volatiity Crossovers? It is to caution you against the defective use of  HV-IV crossovers, which is not a reliable trading signal.   Remember, for a given expiration month, there can only be one volatility over that specific period.   Implied Volatility must leave from where it is currently trading at, to converge at zero on expiration date. Implied Volatility (be it IV for ITM, ATM or OTM strikes) must return to zero on expiry; but, price can go anywhere (up, down or stay flat). To continually sell “overpriced” and buy “under priced” options would eventually cause the implied volatility of every single non-zero bid option to line up exactly.   Meaning the phenomenon of IV’s “smiling” skew disappears, as IV becomes perfectly flat. This hardly happens, especially in highly liquid products. Take for example, the SPY, a broad-based Index; or, GLD – the SPDR Shares ETF in a fast market like Gold. With open interest at the non-zero bid strikes going into the thousands and tens of thousands, do you really think a retail off the floor trader is going to be allowed to “out price” the professional hedger on the floor?  Unlikely. Calls and Puts in highly liquid products, are like items in an inventory with high supply because there is high demand.   This type of inventory does not get “mispriced” because floor traders have to make a daily living from trading the Calls and Puts –they will refuse to carry the risk of mispricing overnight. So, what are the key considerations to banking in your edge as a retail trader? IV’s percentage impact on an option’s extrinsic value is much more sizeable for ATM and OTM strikes, versus ITM strikes which are laden with intrinsic value but lack extrinsic value.   Most retail option traders with an account size USD $25-$50K (or less), gravitate towards ATM and OTM strikes for reasons of affordability. The deeper the ITM you go, the wider the Bid-Ask spread becomes compared to the narrower Bid-Ask spread differences in the ATM or OTM strikes, making ITM strikes more costly to trade. When you trade IV, you are buying time decay for a rise in IV at a % point below; or, selling time premium for a drop in IV at a % point above the theoretical price of market value, that participants are willing to pay or sell for.   Depending on the market ranges of that day, price debit spreads to get filled at 0. 10-0. 15 below the Theoretical Price of the spread.   With credit spreads, raise the credit to sell the spread by 0. 10-0. 15 above the Theoretical Price of the spread.   The price you pay below; or, receive above the Theoretical Price of a spread is your edge, purely based on price-performance of Implied Volatility alone. Remember, you Theoretically Price a spread to fill the order for its forward value, never backward. Where can I learn how to trade options with consistent profits focused on Implied Volatility without Historical Volatility? Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that excludes the use of HV and focuses on trading only IV. I’ll cite these actual historical events, to bolster the argument for removing Historical Volatility from your trading process altogether. 27 Feb, 2007: Widespread Panic from the sizeable China sell-off in equities. If you were trading the options of an index like the FXI which is the iShares product of China’s 25 largest and most liquid Chinese companies though listed in the US; but they are headquartered in China, you would have been impacted. While you can argue it’s possible to have market events recreate the ranges of the Dow, Nasdaq & S&P, how do you recreate the scenario of the VIX and VXN soaring 59% and 39%?22Jan, 2008: Fed cuts rates by 75 basis points prior to the scheduled policy meeting on Jan 30th, whereby the FOMC cut another 50 basis points on the date of the meeting.   If you were trading interest-rate sensitive sectors using the options on a Financial ETF or a Banking Index like the BKX; or, the Housing Index like the HGX, you would have been impacted. And in the current environment of rates being near zero, the FOMC while they still have a rate policy tool, they are unable to cut rates by the same number of basis points like before. What was a historical event is not successively repeatable going forward, not until rates are raised again and subsequently they get cut again. Question: How do you reconstruct history?  That is the history of events forming Historical Volatility.   The answer is in the real examples cited, as with any other financially related historical event – you cannot reconstruct history. You may be able to mimic parts of HV but you cannot repeat it in its entirety.   So, if you continue using HV-IV crossovers, you visually confuse yourself by searching for volatility “mispricing” patterns that you would like to see; but, you will end up with poor profit performance instead.   It makes more practical trading sense to focus purely on IV; then, diversify the trading of volatilities across multiple asset classes beyond equities. Where can I learn more about trading IV across multiple asset classes using only options, without having to own stock? Follow the link below (video-based course), that uses IV Mean Reversion/Mean Repulsion and IV Forecasting, as reliable methods to trade the implied volatilities across broad-based Equity Indexes, Commodity ETFs, Currency ETFs and Emerging Market ETFs.

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Clinton Lee –
About the Author:Please see Consistent Results http://www. homeoptionstrading. com/consistent_results/.
Here’s the summary for month-end July 2009 . . .
❑ Return: Profit/Start of Year Cash Balance = UP +115%! That’s +16. 43% Return per Month!
❑ Win/Loss Probability = 90. 20%. 9 Wins per 1 Loss. Average Win/Average Loss = $3. 66 Won per $1 Loss.
❑ Performance Ratio = (Win/Loss Probability) x (Average Win/Average Loss) = 90. 20% x $3. 66 = 3. 30.
❑ Positive Expectancy = $1,316 per trade.

Preview an original 55 hour video-based course for online options trading from home, at http://www. homeoptionstrading. com/original_curriculum. html
Purchase the curriculum and receive a $800 options basic course as a Bonus!

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Hi, Im looking for historical and implied volatility data on commodity options and was wondering if you know of any free websites that provide this info?
I am having more clients who are interesting to invest money in private placement program in INDIA. Please suggest me the best option for bullet trading. Dr. V. B. Rao Dasari drvbraodasari@gmail. com
What is the best approach to use forex signal in forex trading? Is this driven by fundamental aspect of trading?

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Article Tags:
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Please see http://www consistent results. homeoptionstrading. com / consistent_results /. Here? est? summary of month-end July 2009. . .????? Return: Income / Starting cash balance = 115% UP! That is 16. 43% Return per month !????? Win / Loss Probability = 90. 20%. 9 wins by a p? Loss. Average Win / Loss M = $ 3. 66 won by the p? Loss of $ 1 .????? Performance Ratio = (Win / probability of p? Loss) x (Win Media / P? Average loss) = 90. 20% x $ 3. 66 = 3. 30 .????? Positive expectation = 1,316 d? Dollars per OPERATION? N.Vista after an original course of 55 hours of v? Deo based on options trading in l? Line from home, at http://www. homeoptionstrading. com / original_curriculum. htmlCompra curriculum and receive a $ 800 course options b? musician as a bonus!

The Stealth Greek Of Options Trading: Vega

August 31, 2010 by  
Filed under Option Trading

By: Chris Vermeulen & J. W. Jones
In my previous missives on the Greeks of the option world, we have spent most of our time focusing on Theta and Delta. In the real world of option trading, option prices are the subjects of three primal forces: price of the underlying, time to expiration, and implied volatility.   Delta and theta address the first of these two primal forces. The third primal force, implied volatility, is by far the least known by newcomers to the option trading world. However, while it is usually not respected or even known by many new to trading options, it typically is the most frequently unrecognized force resulting in is the cause for significant trading capital deterioration.
In order to set the framework within which to understand option pricing, it is essential to understand that the quoted price of each option is in reality the sum of the intrinsic value (if any) and the extrinsic (time) value.   The intrinsic value has been discussed previously and consists of the portion of the premium which reflects the extent to which the particular option is “in the money. ”
Understanding of the various concepts of volatility is essential to grasping one of the essential defining operational characteristics of the world of options.   Volatility can be considered in light of:
1. What was (SV, statistical volatility; HV historical volatility; & other synonyms of the same)
2. What is,
3. What shall be (IV, implied volatility, and Market Implied Volatility (MIV) They are all confusingly disparate words and acronyms signifying identical concepts)
Of these three time frames within which volatility can be considered, implied volatility is by far the most important. The nexus point is right here, right now, while the future is unclear and will always be that way. For an option trader to sustain profitability over long periods of time, it is essential to understand implied volatility and its various implications.
Let us consider for a moment the variables defining an option’s price.   Intrinsic value is a crisply defined value that requires simply the calculation of the relationship of the price of the underlying to the strike price of the option and can theoretically vary from 0 to infinity. The time value (also termed the extrinsic value) of the option is dependent, in large part, on two distinct variables. These variables are the amount of time to expiration and implied volatility. Time to expiration is easily defined by anyone with access to a calendar and schedule of option expiration dates. Option expiration is easily accessible for option traders, and as such represents a totally transparent variable. Conversely, implied volatility is not as easy to explain, or quantify.
The subjective concept expressed by implied volatility is to be distinguished from the mathematically objective and precise concept of historic volatility.   Historical volatility is simply derived from the price action of the underlying and can be calculated in one or more of several iterations. Each calculation is fundamentally derived from historically apparent price action.
Implied volatility is not only arduous to understand, it is even more difficult to quantify. A totally different calculation is required; the computation is reflective of a unique and characteristic point of view with regard to price action. It is technically calculated by an iterative process requiring multiple trial and error calculations; thankfully the robust computational ability of the current generation of computers handles this task easily.   Of the three primal forces impacting option price, implied volatility is the only factor subject to cerebration. As an adaptable and subjective input factor, implied volatility is reflective of both general market sentiment and the subjective evaluation of potential future volatility while simultaneously corresponding with the specific direction of the underlying. As such, it is a forward looking evaluation as opposed to historic volatility which is well, historic.
Implied volatility has a historic and characteristic range for each underlying.   A strong historic tendency is the characteristic for implied volatility to revert to the mean for the particular underlying under consideration.   This strong mean reverting tendency forms one of the primary fundamental tenets of option trading and represents a major opportunity for potential profit in option trading.
TheOptionsGuide site produced the chart below that illustrates the behavior of Vega at various strike prices that are expiring in 3 months, 6 months and 9 months when the stock is currently trading at $50.

In addition to the historic backdrop  in which implied volatility may be considered, there are certain stereotypic patterns of IV expansion and contraction in relation to anticipated events which may lead to unusual volatility of the underlying. Classic examples of these events include earnings, impending FDA announcements, and the release of key economic data by the government or the analyst community. For example, many of the most extreme increases in implied volatility anticipate FDA decisions and routinely revert to the mean immediately following the anticipated announcement. Potentially substantial profit opportunities are borne from such situations for the adept and knowledgeable option trader.
In future writings we will address the precise mechanisms by which perturbations in implied volatility can be exploited for profit by the knowledgeable option trader. Failure to consider the current position of implied volatility in a historic framework for the particular underlying in which you are contemplating a trade is the single most frequent hallmark of an inexperienced trader. Lack of attention to this important factor in trade planning is the most frequent cause of paradoxical option behavior and failure to profit from correctly predicting anticipated price movements of the underlying.
While most equity traders focus their attention on the SP-500 for broad market clues, option traders always have a watchful eye on the volatility index, commonly known as the VIX. While the VIX is the most common volatility measurement in the option trading world, there are several volatility indices which can be monitored, followed, and even traded if one is so inclined. While it is not always necessarily the case, recently when the VIX rises, the broad markets are selling off.
While this article has been a basic overview of implied volatility and Vega, it will conclude the series of recent articles which have been focused on the option Greeks. Forthcoming articles are going to be more focused on trades and the unbelievable profit opportunities that can be created by various option strategies. In closing, if you are interested in furthering your education regarding options my recommendation is to do some serious homework. Otherwise it will only be a matter of time before a combination of Theta, Delta, Vega, or implied volatility rear their ugly heads and take money from unsuspecting rookies.
If you would like to receive our free options trading reports and trading signals please join our free newsletter at: www. OptionsTradingSignals. com
J. W. Jones is an independent options trader using multiple forms of analysis to guide his option trading strategies. Jones has an extensive background in portfolio analysis and analytics as well as risk analysis. J. W. strives to reach traders that are missing opportunities trading options and commits to writing content which is not only educational, but entertaining as well. Regular readers will develop the knowledge and skills to trade options competently over time. Jones focuses on writing spreads in situations where risk is clearly defined and high potential returns can be realized.

Chris Vermeulen is Founder of the popular trading site http://www. thegoldandoilguy. com. There he shares his highly successful, low-risk trading method. Since 2001 Chris has been a leader in teaching others to skillfully trade in gold, oil, and silver in both bull and bear markets. Subscribers to his service depend on Chris’ uniquely consistent investment opportunities that carry exceptionally low risk and high return. Reach Chris at: Chris[at]theGoildAndOilGuy[dot]com

Option Trading Software: What Will It Really Do for You?

July 19, 2010 by  
Filed under Option Trading

Option Trading Software With all the problems involved with option trading, a lot of traders are on the look out for an automatic remedy to the rat’s nest of complex calculations involved with accomplishing a money-making trade. Forex traders nowadays have forex robot software on hand that makes their trades for them. Now, option traders are longing for some form of forex trading software application that will do the same thing for them. Now there is such a device that makes option trading a whole lot easier however it’s not exactly the same as the forex robot. So what does option trading software do? The number one challenge of accomplishing a money-making trade is figuring out what the implied volatility of that option is. The option might appear to be heading in the right direction but when you actually perform the trade, you still lose capitol. Why? Because the option was was either under priced or inflated and the killer is that you had no way of knowing whether an option is over or under priced. It’s not listed anywhere. It’s a total shot in the darkand this is what shoots down the majority of option traders. What option traders require in an option trading software platform is the power to determine the real historical volatility in relation to what it is presently selling for. Because, presented with this knowledge, the option trader would immediately be able to execute a successful trade a large amount of the time. Luckily, for option traders, option trading software that does excactly that has finally become available. Below, there is a link to a resource to where you can ge a hold of this sort of option trading software, however, first, let’s look at what it can do for the option trader. First of all, it’s super uncomplicated to use. There is no steep learning curve or monster training manual to get stuck in. All you need to do is run an option through the software and and before you can get another cup of coffee, it lets you know if the option is over priced or under priced. It simply turns out a graph with volatility lines. There is a red dot representing the option itself. If the dot is higher than the lines, it is over priced. If the dot is underneath the lines, it is under priced. It’s a total no-brainer. Now it sounds like this would add on some monthly fee for the data feed necessary to make this option trading software  run. But this is not the case. The  software uses a entirely free of charge data feed so there is no data feed fees at all. And as you would expect, it allows you to store all of your charts and even has a zoom feature to get even more detailed readings. In essence, what this option trading software delivers, is it notifies you very rapidly whether an option is over priced or under priced which informs you when it is time to buy or sell. Super simple but super powerful. Hoever, the best way for you to grasp what it delivers is to follow the link below and find out for yourself.

To get exact details about this option trading software and where you can get it plus a $47 value Forex Secrets ebook for FREE, CLICK HERE or go to http://dirtyforexsecrets. com/option-trading-software

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