Episode 05

Option Trading: Volatility with JJ Kinahan

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Join JJ Kinahan, Chief Market Strategist at TD Ameritrade, and guests as they discuss option trading and an important part of options pricing, volatility.

Audio Transcript

[MUSIC PLAYING]

This is Understanding Options. I'm your host, JJ Kinahan.

[BELL DINGING]

JJ: Hello, everyone. I'm JJ Kinahan, Chief Market Strategist at TD Ameritrade, and welcome to our podcast series, Understanding Options. I'm joined by education coaches Ben Watson and Pat Mullaly. Hello, lads.

Pat: Hey, how are you?

Ben: Hey, guys.

JJ: Today we're going to discuss volatilities and how to use them to plan your trading. So volatility is one of the most important concepts of options pricing, but let's talk about volatility in a bigger sense. Volatility basically means how much something is going to move. So that's where you have to start.

Now, you take that and you put that into options pricing. When it's high, option premiums or prices are higher. When it's low, the exact opposite, options prices are going to be lower. When it's high, we're expecting more movement. When it's low, we're expecting less movement.

It can be a little bit tough, and people will make it really intense when they describe volatility. But at its very core, that's what we're talking about, and it does help to understand. And really, volatility is what drives options pricing. Pat, what do you have say about that, bud?

Pat: Yeah, so true. So volatility levels-- and again, it's very important. These levels reflect what is going on in the product that you happen to be trading. Basically, it's the market's anticipation of what might happen in the future. So when volatility is low, there is less perceived catalyst of a move in the stock, so they don't think there's going to be a big move up or down. Where volatility is higher, there's a perception that there are more factors that can cause that stock movement. So a little bit of uncertainty may increase that volatility.

Ben: You know, Pat, on the thinkorswim platform, it's really easy to get a quick run down on options volatility on a specific stock. So you just simply input the ticker on the Trade tab, scroll all the way down to Today's Options Statistics and open that up, and there you've got that snapshot of implied volatility, as well as an area that is very helpful and that's Current IV Percentile.

JJ: So just defining implied volatility one more time because it really is such an important concept-- it's the estimated movement of a security's price. And again, most commonly used in options. One little thing to keep in mind-- when the market seems to be more bearish, volatility seems to be a bit higher.

Why? There's more perceived risk. When the market is higher, volatility is usually lower as there's less perceived risk. So another way to think about it is as the market goes down, volatility will increase in a normal market. And when the market goes up, volatility will decrease. You know, Ben, anything to add there?

Ben: Well, I think that's a great reminder that it's based on movement. And then, when we just talk about volatility, maybe we add some context. And I think that's where current implied volatility percentile comes into the mix because that number can kind of tell us where that volatility level has been or is compared to where it's been over a period of time.

In this case, a year, so if our current implied volatility percentile number is 75. That means it's in the 75th percentile of where it's been in the last year, so relatively high. If it's, say, 25 or the 25th percentile, that's going to be relatively low because down in the lower quarter of where it's been over the course of the last year.

Now, if you look over to the right-hand side, you can also see Volatility Sizzle, which simply compares today's volatility number compared to the average from the past five days. So you can go to get a short-term look at it, a one-year look using that current implied volatility percentile, and that lets you see volatilities increasing or decreasing, not only in the long term, but also in the short term.

JJ: You know, Ben, you talk about the tools on the thinkorswim platform. And one of the other ones that's one of my favorites is actually the Options Hack. It's a tool that allows you to search for options that are trading within specific parameters in which you set.

So if you want to filter by volatility, if you want to filter by fundamental data, or something near and dear to your heart, Ben, technical data, this allows you to look at inputs in different ways. You can combine using the screener with the Probability Analysis tool once you find a potential trade to get an idea of whether or not an option will be into the money, out of the money at expiration, and most importantly, if it fits what you're trying to do.

Pat: And you know, JJ, there's the options Greek-- I want to toss this in here-- vega. That's the sensitivity of an options premium to changes in that implied volatility. And I think people, oftentimes, especially if they're new, they confuse implied volatility with vega. So vega reflects that volatility in the movement of the options price. So a vega of an option represents an estimate of how much the price of that option will change for every 1% change in that implied volatility.

Depending on your trading strategy and market conditions, you can use different options strategies to create a position that is long volatility, short volatility, or even flat volatility, which is sometimes referred to as neutral volatility. So it's important that people understand that if somebody says they're long volatility, that just means they bought options and they're long that vega.

Ben: Wait, I thought vega was the kind of car you had in college, Pat?

Pat: It was. It was. It had a couple dents, but I had to push it a lot and pop the clutch, but hey, I got there.

Ben: Hey, that works. But look, you talk about that neutral or flat volatility, right, and being long volatility or short volatility. If you buy a call, for instance, you are long volatility because the volatility increases, the value of that option will increase as well with everything else being equal. And if you were to sell a call, you're going to be short that vega or short that volatility and potentially benefit from that decrease in that price.

Pat: Exactly.

JJ: On the options chain, you can look at vega if you want as one of the Greeks, along with delta, theta, and gamma to see what your exposure is there. And then you can go to the Monitor tab and see what your overall position vega is. And again, because volatility is one of the major factors that influences options prices, you should absolutely know what your exposure to volatility is. And anything to add on that, guys?

Pat: Just it's a very important thing when you start amassing a lot of options contracts. And if you feel that there might be a change in market direction, and your exposure to volatility is high, and you think that volatility is going to start to come down, you may want to put on some different types of positions to lower the amount of Vega that you have in your portfolio.

Ben: Right. It's all about putting your assumptions about what might happen in your favor for whatever strategy it is that you're putting to work in your trading account.

Pat: Yep.

JJ: All right, guys. That's great. And great discussion, as always. A lot of fun, and great to have you guys on here today. That's going to conclude today's show. If you're listening, please be sure to subscribe and tune into our next episode. And you can always find more option education at essentialoptionstrategies.com.

You can always find me on Twitter @TDAJJKinahan. You can find my buddy Ben Watson at, Ben?

Ben: @BenWatson_TDA.

JJ: All right, thanks to Pat and Ben for joining us today, adding some handsome to the broadcast. And thank all of you for listening. We really do appreciate it. All the best of luck in your investing and good trading. We'll talk to you again real soon.

[BELL RINGS]

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