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