CHAPTER 3
Understanding Volatility
Most option strategies involve trading volatility in one way or another. It’s
easy to think of trading in terms of direction. But trading volatility?
Volatility is an abstract concept; it’s a different animal than the linear
trading paradigm used by most conventional market players. As an option
trader, it is essential to understand and master volatility.
Many traders trade without a solid understanding of volatility and its
effect on option prices. These traders are often unhappily surprised when
volatility moves against them. They mistake the adverse option price
movements that result from volatility for getting ripped off by the market
makers or some other market voodoo. Or worse, they surrender to the fact
that they simply don’t understand why sometimes these unexpected price
movements occur in options. They accept that that’s just the way it is.
Part of what gets in the way of a ready understanding of volatility is
context. The term volatility can have a few different meanings in the
options business. There are three different uses of the word volatility that an
option trader must be concerned with: historical volatility, implied
volatility, and expected volatility.