Option Trading Strategies Tutorial

Understanding Stock Options Volatility Trading

As with any options trading system, the trader is trying to forecast change in whatever asset is being traded. Let's assume you trade stock. If your forecast is that price will increase then you could take a long position in the stock, purchase a call option or use any other strategy that profits when stock price goes up.

The real question is: How accurately can you predict stock price? If you have ever traded stock you know that price movement can be very chaotic. Stock trading is easier when price is range bound, just moving back and forth between an upper and lower price level. But how do you know when stock price is going to do that? You're back to guessing.

Volatility is a measure that always moves this way. It is range bound. When it gets to a high level that has not been seen but one or two time in the past year or two, then you can count on it dropping. Your probability of being correct is high. This applies if it goes to extremely low levels also. Bet on it increasing. Volatility is called a mean seeking statistic due to this behavior.

Taking advantage of this behavior is what you do in volatility trading. When implied volatility is at extreme low points, then option premium is relatively low. You can take option positions that profit if volatility increases. The converse applies when implied volatility is high. You take option positions that profit if volatility decreases.

Note that the volatility we are discussing is the implied volatility. Continue reading as we explain our option trading techniques.