Volatility 101 — Introduction

Volatility is one of the cornerstones of option valuation. If we talk about the factors that influence the value of the option, then this is the current price, strike, number of days until expiration, and volatility (of course, there is also risk-free rate in the Black-Scholes model, but we will not waste time on this).

And while with the strike, spot, and expiration everything is more or less clear, the volatility is the thing that would never let AMM develop on the options market. Volatility, also known as the standard deviation or the natural logarithm of the price ratio, or the measure of price change.

The stronger the volatility, the wider the range of price changes per unit of time. This is great for short traders, but may not be very pleasant or comfortable for investors.

Going back to options, volatility is a measure of price variability over a period of time. The options market distinguishes between historical volatility and implied volatility.

Historical volatility is an estimate of price change based on past changes. Suppose, for example, the historical 30-day volatility is said to be 40% and the current price of an asset is 100, it means that with a 68% probability, based on 30-day fluctuations, the price will be between 60 and 140 by the end of the year. It should be noted that volatility estimation is usually given in annual terms.

Implied volatility is the way market participants estimate the value of an option here and now, that is, they estimate the range of price change with a 68% probability before expiration in annualized terms. That’s why it’s commonly said that when trading options, you’re trading volatility.

On delta.theta there is a useful index called TV or theoretical value. This is the theoretical option price for a given strike and expiry. When we calculate TV, we use the average historical volatility for 10/30 and 60 days. In other words, it is the price of the option at a highly averaged rate of change.

By understanding what the option price shows through TV or theoretical value, and how it compares to the current volatility, the trader or farmer can choose which strategy (we will consider the basic ones) to focus on, namely:

If IV > TV, that is, the current market situation is above the average position, then sell options. Sell call option in the bear market (SELL HIGH in Lite terminal) and put option in the bull market (BUY LOW in Lite terminal). High volatility moves the premium/option price up. But volatility tends to decrease, so it does not make sense to buy options in this market.

If IV < TV, i.e. the current market situation is below average, then we can consider buying options. The volatility has calmed down and the market has stabilized, perhaps there is a consolidation to further movement.

It is worth noting here that it is always worth bearing in mind the temporary decay when buying options. In case your option is not in the money by the expiration date, you will lose what you spent on it. We’ve dealt with volatility and next time we’ll talk about the Black-Scholes formula.

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