Expected Stock Volatility
Option traders must have an even greater focus on volatility, as it plays a
much bigger role in their profitability—or lack thereof. Because options can
create highly leveraged positions, small moves can yield big profits or
losses. Option traders must monitor the likelihood of movement in the
underlying closely. Estimating what historical volatility (standard deviation)
will be in the future can help traders quantify the probability of movement
beyond a certain price point. This leads to better decisions about whether to
enter a trade, when to adjust a position, and when to exit.
There is no way of knowing for certain what the future holds. But option
data provide traders with tools to develop expectations for future stock
volatility. IV is sometimes interpreted as the market’s estimate of the future
volatility of the underlying security. That makes it a ready-made estimation
tool, but there are two caveats to bear in mind when using IV to estimate
future stock volatility.
The first is that the market can be wrong. The market can wrongly price
stocks. This mispricing can lead to a correction (up or down) in the prices
of those stocks, which can lead to additional volatility, which may not be
priced in to the options. Although there are traders and academics believe
that the option market is fairly efficient in pricing volatility, there is a room
for error. There is the possibility that the option market can be wrong.
Another caveat is that volatility is an annualized figure—the annualized
standard deviation. Unless the IV of a LEAPS option that has exactly one
year until expiration is substituted for the expected volatility of the
underlying stock over exactly one year, IV is an incongruent estimation for
the future stock volatility. In practice, the IV of an option must be adjusted
to represent the period of time desired.
There is a common technique for deannualizing IV used by professional
traders and retail traders alike. 1 The first step in this process to deannualize
IV is to turn it into a one-day figure as opposed to one-year figure. This is
accomplished by dividing IV by the square root of the number of trading
days in a year. The number many traders use to approximate the number of