Calculate Stock Volatility

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Aug 20 Volatility hosted by Tom Preston

(tpreston): Good afternoon, everybody

(tpreston): thanks for joining us

(tpreston): this is the 3rd of our Wednesday online seminars

viper: hi and thanks for having this session

doyleb: HI

graphicsport: hi

(tpreston): we'll be holding them each Wednesday at noon cst

bwang01: hi

(tpreston): today I'll talk about the basics of volatility

(tpreston): I'll go over a few things and take questions after

(tpreston): Volatility is how much variability there is in the price changes of the
stock or index. The more variability there is, the higher the volatility.

(tpreston): A good rule of thumb is to see volatility as representing a 1 standard
deviation move in the stock price in 1 year. Statistically, about two-thirds of the
occurrences will be within plus one and minus one standard deviation.

(tpreston): So, if you see a volatility of 40%, it means that the stock will theoretically
be within approximately plus 40% and minus 40% two-thirds of the time. If the
stock price is \$50, and volatility is 40%, two-thirds of the time the stock will be
between approximately \$30 and \$70.

(tpreston): The formulas that calculate the exact range are more complicated, but
the above technique is a good estimation.

(tpreston): Options depend a lot on volatility. When the marketplace thinks a stock
will be very volatile, the extrinsic value of options rises. When the marketplace
thinks a stock will be less volatile, the extrinsic value of options falls. Keep in mind
that it's the marketplace's expectation of future volatility that is important.

(tpreston): There are two types of volatility you hear about: implied volatility and
historical volatility. They can both be used to estimate future volatility.
(tpreston): Implied volatility is the volatility that, when you plug it into a theoretical
option pricing model, makes the theoretical value equal to the market value of the
option.

(tpreston): An option pricing formula uses the stock price, strike price, interest rate,
dividends, time to expiration, and volatility to calculate a theoretical option value.

(tpreston): To calculate implied volatility, you search for the volatility that would
make the theoretical option value equal to the market price.

(tpreston): If the market price of an option is 3.00, you find the volatility that would
make the theoretical value equal to 3.00. That volatility is the implied volatility.

(tpreston): Historical volatility is when you use historical stock prices, and calculate
the standard deviation of the price changes.

(tpreston): When calculating historical volatility, you have to decide how much
stock data you use. That is, do you use 1 year of data, 6 months of data, 1 month of
data? You can get different volatility numbers for each one.

(tpreston): If you want to use historical volatility, you have to guess which amount
of past stock data gives the best estimate of future volatility.

(tpreston): One thing you can do with volatility numbers is to adjust them for
different periods of time.

(tpreston): For example, if you have a volatility of 30%, which represents the
volatility for a year, how do you calculate the volatility for a week?

(tpreston): What you do is multiply the yearly volatility of 30% by the square root
of the number of days divided by 365.

(tpreston): So, the weekly volatility would by .30 * square root of 7/365.

(tpreston): That equals .0415.

(tpreston): In one week, approximately two-thirds of the time the stock will be
between plus 4.15% and minus 4.15%.

(tpreston): If the stock price is \$50, in one week it would be between \$47.93 and
\$52.08 about two-thirds of the time.

(tpreston): For 2 days, the volatility would be .30 * square root of 2/365.

(tpreston): That equals .0222.
(tpreston): If the stock price is \$50, in two days it would be within \$48.89 and \$51.11

(tpreston): That's the theory, anyway. If your estimate of volatility is too low, the
range will be wider. If you estimate is too high, the range will be narrower.

(tpreston): OK, let me answer some questions

viper: by sing standard deviations and black shcole, arent we giving unfair values
on possiblities on stocks movement(direction)

(tpreston): this model assumes that stock and index returns are normally
distributed

(tpreston): if you think that the returns aren't normally distributed, you wouldn't
use this model

loveoptions: What are some good volatility-oriented strategies for a market where
the VIX is this low?

(tpreston): as for strategies, if you estimate the range of stock prices, you could
create an iron condor that sells calls above the range and sell puts below the range,
then buys a call with a strike higher than the call you sell and a put with a strike
lower than the put you sell.

loveoptions: Hmmm, so an Iron Condor with an extra kicker in case you're wrong

(tpreston): in iron condor has limited risk built in. If you want to make money if the
stock goes outside the range, you could buy more out of the money options

loveoptions: Right... but what I'm hearing is, do the Iron Condor as your most
probable target, and buy the extra OTM calls & puts as cheap boosters in case you
mised the range by a strike or two...

(tpreston): yes, you could do that

loveoptions: interesting... thanks

jackgJAG: Thanks for your intro to the basics. Where do you recommend reading

johuang: Option Volatility and Pricing, by Sheldon Natenburg

(tpreston): Yes, Natenburg is a good resource

(tpreston): some floor traders do, others don't

(tpreston): but all professionals keep an eye on volatility

viper: how about when there is skews between IV and SV?

(tpreston): what is SV?

viper: stastic volatility

(tpreston): never heard of that, but skew is when there is different implied volatility
at different strikes

(tpreston): skew comes about when there is buying or selling pressure at the
different options

bwang01: sv and historical vol. is the same

clchoate: Stastical Vol = Historical Vol ... just another name

viper: perhaps i should have said, diffrences between IV and SV
when IV is much higher than SV...

(tpreston): there are different theories about why it arises

(tpreston): if implied vol is much higher than historical volatility, you have to judge
whether or not implied is more or less accurate in predicting future stock vol than
historical

xqz8cg: When trading options, should we use statistical vol or implied vol?

(tpreston): That's the big question

(tpreston): Implied volatity is actually a pretty good, though not perfect, predictor
to future stock vol

(tpreston): that's because it takes into account all the market's hopes and fears

(tpreston): while historical vol only considers past data

dorila: Tom, can you explain the Skew /No Skew pulldown in the analysis section of
TOS and what is their use?
(tpreston): on the Analyze page, the NO SKEW feature runs all the calculations at 1
single volatility

(tpreston): the IMP SKEW feature uses the current implied volatility numbers for
each option in the position

(tpreston): I would use IMP SKEW all the time

fluxsmith: Interesting that you prefer IMP SKEW, as that's not the default, any
chance of getting that made the default?

kama2: and the skew selection, uses the individual vol of all options being analized?

(tpreston): Yes, IMP SKEW uses individual vols. Having it as default is something
that's on the developers' "to-do" list

viper: so how about average price of iv and sv?(sv+iv)/2? does that sound dumb to
u?

(tpreston): if you want to take an average of historical and implied, you could do
that

(tpreston): for historical, some people use a weighted average of the different time
periods

(tpreston): That is, you give more weight to more recent data, and less weight to
more distant data

gregorio1964: what is wrong, if anything, with re-buying the previously sold legs to
cash some gain, then try to sell again and so on a daily base

(tpreston): if you want to scalp options within an iron condor, you can do that

(tpreston): but realize that you're guessing on the direction of the stock at that
point, and if you're wrong you could get creamed

llangman: what are some online sources for volatility data?
That is, historical info.

(tpreston): For calculating historical, I'd suggest you do it yourself

(tpreston): Yahoo Finance has it

johuang: be aware, yahoo has bad data at times, just want to throw that out there.
optionrat: pcquote.com has historical volatility series

(tpreston): Yes, you have to be careful of bad data from any source. I've never seen
a perfect source

(tpreston): calculate each day's percentage change, then calculate the standard
deviation of the percentage changes

llangman: ok

msadollah: VIX has been giving a sell signal for some time now but the market
keeps ignoring it, does this mean implied vol is way out compared to historical? Is
VI no longer reliable indicator?

(tpreston): The VIX is the CBOE's volatility index

(tpreston): the VIX is the weighted average of the OEX (S&P 100) implied volatility

bwang01: Tom, could you explain why the VIX being below 20 the market has not
moved to the downside? Is it as someone suggested before that
Historical Vol. has been higher than IV (VIX) .. the VIX by itself is a poor
indicator?

kama2: Thats a good question about the market and the low vix

xqz8cg: what is IMP?

bwang01: implied

(tpreston): generally speaking, low VIX means higher index prices, and higher vix
means lower index prices

(tpreston): it's not that surprising to see VIX this low after the rally for the past 5
months

bwang01: it has been low for a decent time now

bwang01: i'm sure it can get lower

(tpreston): think of it like this, VIX goes up with uncertainty and fear

(tpreston): The VIX was much higher last winter, with all the fear about Iraq
(tpreston): with the war over, and economic data not entirely bad, and with stocks
up, there is less fear, and the VIX is lower

kama2: It seems that Oct iv's are higher than Sept's iv's. How do you read this?

(tpreston): Most of the time, back month vol is higher than front month vol

(tpreston): it depends on the market's expectations.

(tpreston): Last winter, the front month vols were higher, indicating short term
uncertainty

xqz8cg: How does VIX calculated?

(tpreston): I don't have the exact calculations for the VIX, you can get that from the
CBOE. But it is a weighted average of the at the money OEX options with at least
30 days to expiration

kama2: Putting on time spreads when the iv is low is a good stradegy if iv goes up?

(tpreston): yes, because time spreads have positive vega

(tpreston): anytime you think vol will rise, you want positive vega

graphicsport: Using an Elliott Wave type analysis on the VIX, it looks like it could
be heading down to the 16.73 area. We could see 16.37 on the VIX by the middle of
September. Just a projection....

msadollah: By looking at VIX I have been bearish for the past 3 months and been
punished , should I stop paying attention to it?

johuang: no one indicator will make a complete system

(tpreston): I don't really like picking direction. The VIX is best used as a measure
of the overall movement of the OEX, not the direction

loveoptions: Low VIX means it won't move much, not that it will head up or down
in specific, right?

(tpreston): right

(tpreston): and in that sense, the VIX is pretty accurate

loveoptions: So best bet is to play range trades that assume it staying near where it
has been?
(tpreston): yes, unless you think the future volatility of the OEX will be more than
what the VIX indicates

kama2: so generally stay away from Time spreads when iv is high unless there is a
big difference between front and back month?

(tpreston): Time spreads are tough because most times they don't have great
risk/reward ratios

(tpreston): you have to get very close to the short strike at expiration for it to make
money

(tpreston): if the back month vol is much less than the front month vol, then the cost
of the time spread will be lower

(tpreston): that would give it a better risk/reward ratio

(tpreston): Time spreads are bets that the stock is going to be at the strike price at
expiration

(tpreston): but so are butterflies

(tpreston): the difference is that a butterfly will give you a better reward if you're
right

seagull: Any thoughts about how to do delta neutral trades now-does that seem like
a good idea??

(tpreston): buying straddles and strangles is a decent bet if you think vol will rise

(tpreston): but you're battling time decay with those

(tpreston): Delta neutral trades like long straddles would make money if vol rises
quickly

(tpreston): but buying low vol and selling high vol doesn't necessarily mean you
make money

(tpreston): you have to take into account the passage of time

(tpreston): long straddles lose money as time passes and if vol doesn't go up or the
stock doesn't move big

(tpreston): and if vol doesn't move up until close to expiration, you might still lose
money
(tpreston): Gamma scalping (which we'll cover in future chats) is a way to trade

llangman: do you think butterflies are good trades in
a low IV environment? that is, are they priced
higher in low IV period?

(tpreston): butterflies drop in value when vol is high, and rise in value when vol is
low

(tpreston): you have to decide whether you think the stock is going to stay in the
butterfly's profit range or not

(tpreston): OK, I have to wrap up

kama2: Assuming that iv stays low for an extended period of time, what stradgies
should we be focused on?

(tpreston): if you think vol will stay low, butterflies and condors are good trades to
look for

(tpreston): If you want a transcript of this chat, send an email to
tradedesk@thinkorswim.com and we'll forward one to you

lotz9ez: That was good Thanks

fluxsmith: Thank you. Looking forwart to a gamma scalping chat, hope that's
coming up soon <g>.

loveoptions: Thanks Tom!

Scott: thanks

(tpreston): You're welcome

(tpreston): and thanks for coming

(tpreston): See you next Wednesday

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