Trading volatility; an investing method typically employed in stock option trading, measures the risk of an option over time. In theory, the chances of an instrument’s price being further out from the current price increases over time. Thus, the volatility must be taken into account when selecting an option trade.
Three CBOE volatility indexes
1) The CBOE (Chicago Board Options Exchange) shows the market’s expectation of 30-day volatility under the ticker symbol; VIX. Based upon implied volatilities of S&P 500 index options it provieds a broader measure of market risk. The VIX is also referred to as the ‘fear gauge’ as stock investors’ reactions are visible in price movement. The VIX. (CBOE introduced the VIX in 1993 based only upon eight S&P at-the-money put and call options, and expanded to cover S&P 500 approximately ten year after)
2) The VXN displays volatility based upon the Nasdaq 100 and it is
calculated using the same system as the VIX. However, the VXN characterizes implied volatility of a theoretical 30-day option that is at-the-money.
3) VXD tracks the Dow Jones Industrial Average (DJIA) and it is a reflection of ‘anticipated’ stock market volatility for this index.
Why does trading volatility matter?
By its very definition; volatility means to change suddenly in an unpredictable or potentially dangerous manner. It only makes sense to place as many odds in your favor when trading stock, and these indexes were devised to help stock market investors make an educated guess about implied volatility. The higher the volatility the higher your risk for placing the trade, and the harder it becomes to profit. Just one of the many facets of how the stock market works.
The ability to measure volatility becomes extremely important in stock option trading Not only do option traders predict future price direction, they must work against time decay during the time-frame they plan to hold their option position. Regardless of your particular trading style, all stock traders can take a look at the trading volatility indexes to measure investor sentiment.
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