The Nature of Market Volatility
Risk comes in many forms and, as a result, your definition of risk tolerance has to take the different forms of risk into account. A study of price volatility is a good place to start. Volatility can and should be applied to individual issues. This does not mean that overall volatility trends should be ignored; however, because listed options are specific to a single stock, the study of volatility can be used to measure risk, to identify market conditions, and to find option opportunities.
Market volatility follows cyclical patterns just as prices do.
When prices for specific stocks, sectors, or the overall market rise rapidly, we usually also see increases in the volume of shares traded. A short-term rally is characterized by a corresponding short-term volatility, meaning prices can change in both high and low directions within a single day or week. A longer-term rallyâlasting several weeks, for exampleâwill tend to be broader based. Market volatility will slow down as the rally begins to lose its momentum, which is one way to identify the top of the marketânot always, but often.
Being aware of the patterns and tendencies of market volatility does not necessarily provide you with a key to the timing of option decisions. In fact, in the most volatile of markets, it is the uncertainty of the timing of events that makes the market the most interesting, and the most dangerous.
Smart Investor Tip
Volatility introduces both risk and opportunity. The very uncertainty associated with big price swings provides options traders with the best environment for profitsâif properly understood.
Volatility is an expression of conflicting investor interests converging at the same moment. A high demand or a high supply resulting from greater-than-usual volume has an immediate effect on stock share prices and on option premium levels. When time value is distorted during high volume periods, it creates a momentary advantage for options traders. Distortions occur most often during highly volatile periods for a specific stock, but the offsetting market reaction tends to correct the condition within the same trading day. So to take advantage of time value price distortions, you will need to track the market throughout the day.
Smart Investor Tip
Options traders who plan to take advantage of short-term price aberrations have to be prepared to track prices closely, and to act quickly.
By Michael C. Thomsett