by Dave Caplan

Implied volatility is configured differently in different commodities.  We know that the at-the-money implied volatility is the universally recognized volatility for a particular series of options.  The magic in discovering that different strike prices of options in the same series may trade at different implied volatilities is the necessary basis for uncovering and using many different trading strategies.  Being aware of this phenomenon permits it to be used in the trader’s decision making process.

In-the-money value, or intrinsic value, the amount of days until expiration, and the interest rate are all components of an option’s premium.  Does that mean that every time a futures contract is at a certain price, an option with the same time to expiration, and strike price, given interest rates are constant, will have the same value?  For example, if a T-Bonds futures contract is at 107-16 and there are 90 days until option expiration, should the 108 call always be priced at $2,000.00?  All the fixed components are the same; the futures price, the strike price, the time to expiration, and the interest rate.

We can call these the “known” variables.  What if the next time the futures are at 107-16, the 108 calls with 90 days until expiration are priced at $2,500.00?  Is this an incorrect price?  If someone is willing to buy or sell this option at this price, it must be the right price at that given time.  What is the unknown variable?  What is the secret component of options pricing?  Although the answers to these questions may not have as much importance as determining the reason for human existence, they are as significant in understanding and trading options.

The unknown component contained in the price of an option is similar to the unknown variable to futures trading: Where is the market going and how fast is it going to get there?  Many market watchers and traders believe they have the ability to predict the future movement of the market.  Market forecasters make future predictions based on past information.  Everyone knows where the market has been.  However, no one can predict the day-to-day movement of any market in the future.  Yet every trader has an opinion of where the market is going.  The options trader is not only concerned with direction, but the range and rate of market movement in either direction.  Volatility is the most difficult and important factor in option trading.  However, in all but the most advanced books, is it given its deserved attention.  And even when it is discussed, little more than definitions and general concepts are presented.  This is surprising to us, because both our research and actual trading have shown that volatility is the most important, while also the most overlooked and misunderstood aspect of option trading!

Options traders, on any level have to learn from their trades.  There is no substitute for hands-on experience in all aspects of trading.  An essential part of gaining experience is the process of evaluating a trade; from the thought process and reasoning of why the trade was initiated, to the explanation of the net result when the trade is offset.  If a position made or lost money, the trader has to ask, “Why?”  Many times a trader will make money for the wrong reasons, not considering the volatility effects, and repeat the same technique over and over.  This typically results in being categorized with the majority of non-professionals, a loser 80% of the time.  By running through the “volatility thought process” throughout the duration of a position, the options trader will be learning successful evaluation techniques.  Mastering these techniques will increase the probability of success in your trading.  The steps of the volatility thought process are:

  1. Measure both current implied (at-the-money or near the money average) and the relevant historical volatilities.
  2. Convert these percentages into expected ranges for the underlying instrument.
  3. Compare the current levels of the volatilities to their normal bands.
  4. Be aware of the volatility trend.
  5. Based on the above, determine a range of your forecast volatility.  This forecast range should be kept simple: higher, lower or equal to the current volatility.
  6. Examine the approximate expected range of the underlying based on your forecast volatility.
  7. Examine the volatility skew of the options series.
  8. Based on your evaluation of volatility and the market trend (the technical pattern), decide whether this is an option position that will provide a “trading edge” over the markets.

After going through these steps, the options trader is prepared to make a trade determination.  The trader should review these steps at regular intervals after the trade is initiated.  There is nothing wrong with changing an opinion.  The object is not to be right on any forecast, but to make money.  Options are flexible vehicles, and options traders should always remain flexible.  The stubborn trader, or the trader who is afraid to admit to being wrong, cannot be successful, no matter how much knowledge he or she has.  You can use these steps to make better and more informed trading decisions.