VOLATILITY EXPLANATION

<H1>VOLATILITY EXPLANATION</H1> <HR> Volatility is how much variability there is in the price changes of the stock or index. The more variability there is, the higher the volatility. A good rule of thumb is to see volatility as representing a 1 standard deviation move in the stock price in 1 year. Statistically, about two-thirds of the occurrences will be within plus one and minus one standard deviation. So, if you see a volatility of 40%, it means that the stock will theoretically be within approximately plus 40% and minus 40% two-thirds of the time. If the stock price is $50, and volatility is 40%, two-thirds of the time the stock will be between approximately $30 and $70. The formulas that calculate the exact range are more complicated, but the above technique is a good estimation. Options depend a lot on volatility. When the marketplace thinks a stock will be very volatile, the extrinsic value of options rises. When the marketplace thinks a stock will be less volatile, the extrinsic value of options falls. Keep in mind that it's the marketplace's expectation of future volatility that is important. There are two types of volatility you hear about: implied volatility and historical volatility. Implied volatility is the volatility that, when you plug it into a theoretical option pricing model, makes the theoretical value equal to the market value of the option. An option pricing formula uses the stock price, strike price, interest rate, dividends, time to expiration, and volatility to calculate a theoretical option value. To calculate implied volatility, you search for the volatility that would make the theoretical option value equal to the market price. If the market price of an option is 3.00, you find the volatility that would make the theoretical value equal to 3.00. That volatility is the implied volatility. Historical volatility is when you use historical stock prices and calculate the standard deviation of the price changes. When calculating historical volatility, you have to decide how much stock data you use. That is, do you use 1 year of data, 6 months of data, 1 month of data? You can get different volatility numbers for each one. If you want to use historical volatility, you have to guess which amount of past stock data gives the best estimate of future volatility. One thing you can do with volatility numbers is to adjust them for different periods of time. For example, if you have a volatility of 30%, which represents the volatility for a year, how do you calculate the volatility for a week? What you do is multiply the yearly volatility of 30% by the square root of the number of days divided by 365. So, the weekly volatility would by .30 * square root of 7/365. That equals .0415. In one week, approximately two-thirds of the time the stock will be between plus 4.15% and minus 4.15%. If the stock price is $50, in one week it would be between $47.93 and $52.08 about two-thirds of the time. For 2 days, the volatility would be .30 * square root of 2/365. That equals .0222. If the stock price is $50, in two days it would be within $48.89 and $51.11 about two-thirds of the time. That's the theory, anyway. If your estimate of volatility is too low, the range will be wider. If you estimate is too high, the range will be narrower. Also, the statistical model used assumes that stock and index returns are normally distributed, and that volatility is constant, that is, it doesn’t change over time.As for option strategies that can be used to trade stocks or indices once you’ve determined the possible range, iron condors, butterflies, double diagonals, straddle strangle swaps, and time spreads are good choices that have limited risk and positive time decay. RED Option has advisories for each one of these strategies, and also supplies the probability of profit for each of its recommendations.