Historic Volatility
Indicator Type:
Non-Indicator
Introduction:
The Historic Volatility indicator is used mainly as an option evaluation tool.
It does not give trading signals like those given with other technical
indicators. What it does do is give the trader an idea of how volatile the
market has been for the previous period of time. Changing the period of time the
study observes allows the trader to fine tune options prices. If a market has
been extremely volatile for the past 3 months, for example, then near term
options should be more expensive. If the market has been calm for an extended
period of time longer term options should be reasonable. Its use in futures is
for observation. Telling the trader if prices are calming down or becoming more
erratic.
Interpretation:
The key to using historic volatility is determining the correct period of
time for each market. The market you are looking at may show a history of
volatility years ago but may have been relatively calm the last few months.
Getting an idea of the markets behavior recently may be of no use to the trader
that is looking at distant options and vice versa for the trader looking at near
term options.
For the futures trader this tool is useful as a guide for order placement.
Seeing that market volatility is changing may indicate that it is time to move
stops closer or farther away. If the trader is profitable with the trend and
volatility is changing it might be a time to move stops closer to protect
profits. If a trader is trading against the trend, they might want to move stops
further away to avoid getting bumped out prematurely.
Options traders could use this study to help them purchase profitable options.
The basic idea is to buy options when volatility is decreasing to take advantage
of a change in that volatility. Any rise in volatility will translate to an
increase in option values. Look at options strategies that take advantage of low
volatility, such as straddles or ratio spreads. When volatility is high selling
options would be better, because any decrease in volatility will translate to a
loss of option value. Option strategies that take advantage of a decrease in
volatility are strangles and regular short option positions.
See Gecko Software’s Options Seminar CD-ROM for an explanation of these
stratagems.
Obviously, historic volatility is only one component of option pricing. Any
changes in the underlying futures market could negate the changes in option
prices due to volatility. For example, if you were to buy a low volatility Put
option and prices go higher that option will lose value but not as quickly as a
higher volatility option.
For the futures trader the basic concept is to expect market changes during
periods of increased volatility. George Soros the trading legend said “Short
term volatility is greatest at a turn around and diminishes as a trend becomes
established.” This indicator is commonly viewed as very mean regressive. What
this term means is that the historic volatility indicator tends to return to the
opposite end of the spectrum and therefore return to an average. If volatility
is great it will eventually cool off and return to that place. If volatility is
low it will not stay quiet forever. What this means to traders is that a market
that is erratic will sooner or later calm down and a market that is quiet will
eventually get loud again.
