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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 about two-thirds of the time. (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 about the max range? (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 more about volatilty in option trading? johuang: Option Volatility and Pricing, by Sheldon Natenburg (tpreston): Yes, Natenburg is a good resource msadollah: do floor traders use vol in their daily trades?, should we? (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): You can download daily historical stock prices from the internet. (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): You download the price data and put it in a spreadsheet (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 straddles/strangles 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 msadollah: thanks (tpreston): You're welcome (tpreston): and thanks for coming (tpreston): See you next Wednesday

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Stock Volatility, How to, Stock price, Market Volatility, historical volatility, standard deviation, implied volatility, the Stock Market, expected return, calculate interest

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posted: | 11/14/2010 |

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