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Understanding the role of volatility in options markets

Agriculture.com Staff 11/18/2009 @ 2:37pm

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'm still amazed at the number of investors and speculators in my market who don't have a good handle on what I do for a living. Just ask my wife or my sister. When the subject of careers comes up, they say I don't have one.

In my job, it's important to know how money is lost. It took me a while, but it comes down to one thing. Volatility. What is volatility? Many people have written about it, and I'm positive I am one of those who read what they wrote. But it didn't help me in my time of strife.

You may have heard traders or brokers speak about volatility, yet no one puts it into understandable terms. So I will try.

First, we should talk about historical vs. implied. I wasn't sure what that meant when I first started, but I can put it into terms that make it simple now.

  • Historical Volatility is a measure of price fluctuation over time. The time frames are usually 30, 60 or 90 days. But it can be applied to different preferences and different time frames. What has been the historical volatility of this contract over the last X time frames?
  • Implied Volatility is the volatility of an underlying, as prescribed by the prices of the options.

So, what do these mean to you and me?

The first definition doesn't really mean anything to an options trader except for its relevance to the second definition. A trader would ask, for example, are options prices being modeled near the historical volatility of the underlying that I'm trading? Or is there a significant difference?

If the historical volatility of corn futures is 18%, I'm 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's been 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.

That's a mouthful.

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.

We (options specialists) use computer models to generate the options models and the tables that we use to make options prices.

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