A to Z in Three - Volatility
The dictionary defines volatility as instability, unpredictability, or explosive nature. You’re probably more familiar with the word being associated with emotions, volcanoes, chemicals, or even the temper of Homer Simpson when there are unexplained missing pink doughnuts.
When we talk about volatility in the stock market, it means the same thing. The only difference is that we’re talking about the unpredictable or erratic nature of prices.
When you hear phrases like, “The Nasdaq 100 is more volatile than the S&P 500” or that “Google is more volatile than McDonald’s,” it just means their prices jump around a lot more; they are less stable and therefore less predictable from day to day.
To use an everyday example, we can say that gas prices are more volatile than milk prices. You’re pretty sure that the price you pay for a gallon of milk over the next three months will be pretty close to the price you pay today. There is usually not a lot of variation in milk prices from month to month except for maybe a few cents here or there. Milk prices have very low volatility.
However, you’re not so confident about gas prices. The price you pay for a gallon of gas in three months could be far different (whether higher or lower) than what you pay today. Gas prices are highly volatile.
Most option traders are aware of this basic concept of volatility yet mistakenly believe that the reason for understanding it is to identify which stocks are best for trading options. High volatility does not make for a better option purchase. The reason is that high-volatility stocks have high-priced options. The advantage of volatile stock prices does not come for free anymore than the advantages of owning a Ferrari or an ocean-front home. In other words, if you want the benefit of high-volatility stocks, you must pay for it.
So why bother understanding volatility? The reason professional traders measure and track volatility is because it allows them to identify an option’s value. Everyone knows the price of an option by looking at the quote. That’s easy. But what’s it really worth? That’s the $64,000 question. And that’s what volatility helps to answer. Price and value are two different concepts. As Warren Buffett said, “Price is what you pay. Value is what you get.”
What happens if you pay more for an option than its value? That’s the crucial question to understand. The unnerving answer is that you will lose money on the option – even though you were correct about the stock’s direction.
Most option traders have encountered this frustrating experience at some time. They buy a call, the stock price rises, but the option loses value. They often attribute this bizarre behavior as a proof that option prices are manipulated behind the scenes. The reality is that they simply paid too much for the option. The option’s price was greater than its value. And the answer would be plainly visible if they understood volatility.
Market makers do not set prices. Market makers post prices on the quote board according to order flow. The market – investors like you and me – sets the price. The market maker just records it.
But sometimes investors place prices on options that are far different from the value. Those moments can be traps. They can be opportunities. And only through the eyes of volatility will you know which is occurring.
Our three-day volatility course takes you on a journey through the basics – from A to Z – of volatility. We’ll demonstrate with a simple example in the class how easy it is for prices to stray from value. You’ll understand the definitions and mechanics. You’ll know how to look up and measure volatility. At the end, you’ll know how to separate an option’s price from its value.