Options Trading

Before we discuss volatility and how it is used in Options trading we need to understand some basic principles that underpin the theory of volatility in options trading.

We have to make some assumptions the first one being that the markets are random. What do we mean by this? when we talk about the markets being “random” in options trading we are making the assumption that the odd of an assets price going up is equal to, or identical to an assets price going down.

The other assumption we make is in regards to the assets price distribution, in other words the price movement is log normally distributed. In plain English what this means is that not only is the direction of the price random but also the magnitude of the movement is also equal.

Once we have these principles we can convert the random  log normal distribution into something we can use for options trading and that is volatility.

Whilst a trader does not really have to understand the mathematical aspects of this is it nonetheless good to have a basic overview of how volatility is calculated and how this is then used in options trading.

The easy thing about normal distributions is that they have properties that are closely tied in with statistics which then allows a trader to use some simple mathematical formulas in options trading.

Let us briefly look at the definition of Volatility.

Mathematically, volatility is defined as one Standard Deviation of the daily logarithmic price change, Annualized.

Volatility is a measure of an underlying asset’s absolute rate of return and absolute risk. In options trading, a trader would simply use volatility to measure an underlying asset’s absolute price movement.

It is not in the scope of this article to show the mathematical formulas but one can simply get these from a standard spreadsheet like excel.

So basically we have, the date that is the day ( this is a 20 day time period) next we have the days price divided by the previous days price, then we have the logarithm of the daily price change. So now we are able to get Standard Deviation from those logarithms.

Finally we take the standard deviation and annualize it by multiplying the standard deviation by the square root of 365 ( days )

So what how is volatility useful to a trader of options?

• Volatility is defined in terms of Standard Deviation this now means that we have a means of measuring price swings which allows us to use statistical data.
• Volatility can be used to calculate probability.
• Volatility is used to calculate an options value.

This is why volatility trading has for many years been the exclusive domain of wealthy traders and bankers because the average person or trader simply did not have the resources or the  know how to apply this in options trading.

We have changed this for you, you don’t really need to know how to do the raw mathematics because we have a program that will do everything for you. All you have to do is simply input the prices. For now however it is important to have the basic overview of how this trading system works with options trading.

Options Trading