wmeubank@ocp.kcmo.com
OPTIONS
Prepared by
Ira Epstein & Company
Volatility: Friend Or Foe?
Many traders are overly concerned, in my opinion, with price direction that is...whether the market will move up, down or sideways. Isn't that the whole idea? Well, an option strategist might disagree. Me, for instance. It doesn't do you as a trader any good to buy a future's option contract, even if you are right on direction, if you cannot withstand the volatility.
All of this leads to the question “What the heck is volatility?” For all practical purposes, volatility simply refers to the magnitude of the price swings on the futures contract. Because prices normally oscillate back and forth, rather than move in straight lines, a random oscillation is quite capable of wiping out a reasonable stop and closing out a position with a loss, before making a significant directional move.
Volatility is also key to option pricing. Wildly fluctuating markets tend to drive up option prices. Quiet markets tend to yield relatively inexpensive options. Option traders are simply willing to pay more for an option that appears to be “within range” of the futures price.
“Implied volatility” attempts to quantify the probability that an option will expire in the money based upon whether or not the option price (premium) is relatively expensive or not.
Now, how do you attempt to profit from all these wonderful concepts? The quick answer is that you try to combine your directional play (purchase of a call, for instance) taking into consideration volatility. The same call will be much less expensive if you buy it when the market is quiet, rather than when it is volatile. Ideally, you want to sell volatile option markets and buy quiet ones. Your goal should be to combine volatility and price direction. Of course, like any worthwhile endeavor, it's easier said than done.
October 7, 1997 Tim Zurick
Ira Epstein & Company
223 West Jackson, 7th Floor, Chicago, Illinois
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Last updated on 10-10-97
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