The Secret to Understanding Stock Market and Options Volatility
Volatility is the measure of risk relative to the change of price involved when observing the value of a security or option. Higher volatility implies a wider range of value potential for a security or option while lower volatility implies a small range of value potential for a security or option.
While there are various types of volatility such as current and historical, the focus should be on the future cost of risk (volatility) as that is literally where the money is. Current volatility is the price of risk now. But, that “now” price for volatility is understood by anyone simply by observing the current market dynamics. Historical volatility measures what has happened in the past. But, the past is not a map to the future. The past is merely a “what if” guide. What needs to be deduced is the future cost of risk that we know of as volatility.
When studying any market, always begin and end with price. Certainly all things tangental to price should be examined and explored, but always conclude any study with its current price. This is so when measuring volatility. The best measure for calculating volatility is what is known as the “length of the line” method!
The “length of the line” method involves measuring the range of price during a period certain, relating that measurement to previous calculations. For instance, if during any trading day (call it “day 1”), a stock moves from its opening price of say 28.00 to 28.50, then reverses in price (the 28.50 being the highest level for that period of time) to 28.00, following that bottom price moving back up to 29.00 where it closes in price for that day, the “length of the line” that day for that stock equals 2pts. The calculation of that is as follows: 28.00 to 28.50 = .50; 28.50 to 28.00 = .50; 28.00 to 29.00 = 1.00 (add .50 plus .50 plus 1.00 to get 2.00, the “length of the line”). Another way to think about the “length of the line” is to imagine that if in this example, the stock was bought at 28.00 on the opening price; sold at 28.50; shorted at 28.50; covered at 28.00; bought again at 28.00 and sold on the close at 29.00. Doing all that would equate to a day trading profit of 2 points, or $2.00 per share traded.
Now imagine that the next trading day (“day 2”) has this same stock open at 29.00 and move steadily up during the entire day, closing at 30.00. The profit made by anyone long that stock would be 1pt (30.00 minus 29.00 = 1 point). That profit would also be the “length of the line” for that particular day. Traders would conclude that the volatility of the previous day far Exceeded the volatility of this day as the stock did not “move around” intra-day as much on day 2 as it did on day 1. Traders make their money on any daily movement which has the “length of the line” rising, not falling.
Traders price volatility of options as well as influencing the volatility of stocks during any trading day. The reason that fact is known is found in the numbers. This is so because when added up over a very short period of trading days, the daily volume in dollar terms during those trading days accounts for far more than the total value of all stocks in the United States. It would be ludicrous to think that the entire ownership of all companies in America changed hands every few weeks to months! So suffice to conclude that most of the volume during any given trading day is about 75% pure speculation and nothing more. Most of the trades during any given day are thus “hedged off” near or on the close of any trading day.
When a stock is not acting volatile intra-day relative to its known current “length of the line” average, yet its options (puts or calls) begin to rise in price, that is a huge signal that something has changed in the underlying stock’s dynamic and what is happening is that “something” unknown as of yet, is being immediately priced into the stock via the price of the puts or calls. Never ever “fight” a change in value such as this type as you most likely will lose money trying. This price change (stock does not change in price yet its options go up in price) is known “positive (as per price change) revaluation”. The reverse of this would be “negative revaluation”, which occurs when the stock does not change in price yet its options decline in price.
Most of the time a rise in the price of volatility begets a stock or stock market decline because the risk premium to those who are long stocks is rising, the precursor to poor stock/stock market news about to become known to all. However, it is not 100% syllogistic logic to conclude that rising volatility or the price of it always precedes a decline in stock prices! Consider a stock or stock market that is heavily shorted, only to be met head-on with surprising positive news that would normally affect the stock or stock market. At that point, those who have sold short must scurry to cover their short sales or pay the price for not doing so. When short sellers begin to cover short sales positions, they tend to do so in a “New York minute” and with a vengeance as to timing and price. Add to that condition all of the new players who now want to buy to go long, and you get a stock or stock market that has almost only buyers and very few sellers. That condition can explode volatility immediately and with serious consequences.
To conclude, the key to understanding volatility and its cause of change lies mostly with the “length of the line” and certainly with how far and fast prices are changing. If it is the price of the underlying options that are changing with no noticeable change in the price of the underlying stock or stock indices, then it is best to rely on the options that are being revalued in order to gauge the new price level of volatility.