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How To Get An Edge In Stock Option Trading

Aug 17, 2007
A good understanding of volatility is important to option trading. A misunderstanding of this topic could leave a trader with losses and frustration as to why their trades that and go as planned. In this article, I am going to discuss the two primary types of volatility that an options trader may want to consider before placing their trade.

There are two types of volatility that should be considered before placing an option trade. The first type is called implied volatility and is more closely tied to the options price. The second type is called statistical volatility and is more closely tied to the price of the underlying security.

Statistical volatility is sometimes referred to as historical volatility. It's a measure of how volatile and market is and reflects the day-to-day fluctuations of the prices for that market. So, a market with a statistical volatility of .90 will be more volatile than one with a measurement of .25.

Implied volatility is derived from an option pricing model. It's the volatility that is implied in the price of the option. If traders who are involved in option trading are expecting some future event to radically move prices of the underlying security, they may want the buyer to pay more for the option that they are selling. When this happens the implied volatility increases. However, if the option seller is not very excited about what could happen in the future, options prices may reflect very little implied volatility.

So, how is all of this useful? When options traders compare statistical and implied volatility they can determine whether or not the option's price is over or undervalued based on the difference between these two values. If the implied volatility is higher than the statistical volatility, the option's prices would be more expensive than if the option's pricing model reflected the implied volatility closer to the statistical. If the statistical volatility value is higher than the implied, it would mean that the option prices are cheap because the daily fluctuations are greater than the anticipated future price movements of the underlying security.

Some traders fine option trading very rewarding. And, a good understanding of these two topics will go a long way in the education and trading results of options trader. This is especially true if the option trader buys options or options spreads for a net debit.
About the Author
Sam Perdue has been actively trading the markets for over 13 years. He has written a computer program that helps traders analyze the stock, Forex, commodities and options markets using Fibonacci ratios, Elliott Wave, option pricing and nonlinear programming algorithms. For more information, please see our option trading software.
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