Market volatility and fishing bobbers
I am a seasoned pit trader. I have stood back to face for 20 years sharing sweat in different pits around the world. My specialty is options. After all these years I am still amazed at the amount of investors and speculators in my market that don't really have a good handle on what I do for a living. Just ask my wife or my sister. At career day they say that I don't have one.
I am often asked about options and what is the most difficult thing to understand. As I write this article I think back to my beginnings and often wonder if there was a defining moment that could explain why I have pursued this line of work. Firstly, I am still learning the trade. I think if you ask any professional athlete the same question they would give you similar answer. We are like professional athletes. There are many of us that want to be in the pits but only a few can make a lasting career out of the chaos. The chaos will give way to electronics soon but the fundamentals of the trade will be the same.
After two years of training when my brain was at its brightest, I was promptly put into the corn options pit as a young 22 year old ready to make his killing. Within my first week I was the one getting killed. Why? Well, I believed I was very well trained. I had passed two difficult company exams and earned the trust of my employers. They had backed me with their in-house education as well as their capital. All I had to do was put them both together and the world was my oyster. I could not have been more wrong.
It was like a puppy dog hearing himself bark for the first time. Was that really me? Was I responding to the right broker in the correct manner? Was my price right and did he/she execute the trade with me? The red mist had descended and if there was a fire in the building I could not have found my way out.
How did I lose the money? It took me a while but it comes down to one thing. Volatility. What is volatility? I am sure many people have written about it and I am positive I am one of those that read what they all wrote but it didn't help me in my time of strife. You may have heard other traders/brokers speak about volatility but nobody ever really puts it into terms that you and I can understand. I am going to give it a try.
First we should talk about implied versus historical. I wasn't sure what they meant when I first started but I can put them into terms that make them simple now.
- Historical Volatility: A measure of price fluctuation over time. The time frames are usually 30, 60 or 90 days but can be catered to different preferences and different time frames. What has been the historical volatility of this contract over the last X time frames?
- Implied Volatility: The volatility of an underlying as prescribed by the prices of the options.
So, what do these mean to you and I?
The first definition doesn't really mean anything to an options trader except for the relevance to the second definition. For example; are options prices being modeled near the historical volatility of the underlying that I am trading or is there a significant difference? If the historical volatility of corn futures is 18% I am going to be careful about getting long options with a volatility of 25%. Those options at 25% are forecasting a future historical volatility of 25% but in reality it has been only trading at 18%. Either the market knows about a significant upcoming event or there is a high likelihood that the options being priced today are reflecting an unnecessarily high future historical volatility.