Volatility Trading - Call and Put Options - Trading Tutorial

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What is volatility trading?
Volatility trading is the term used to describe trading the volatility of the price of an underlying instrument rather than the price itself. For example, you could trade the price direction of an equity index, but volatility trading typically means trading the expected future volatility of the index. Any instrument whose price moves, exhibits price volatility. Volatility trading is simply buying and selling the expected future volatility of the instrument. Rather than predicting whether the price of an asset will move up or down, volatility traders are concerned with how much movement, in any direction, will occur.

How is volatility traded?
The most common way to trade volatility is using options. The value of an option is affected by several factors, but an essential determinant of its value is the expected future volatility of the underlying instrument, which is included in the pricing formulas as standard deviation. Other things being equal, options struck on an underlying with higher expected volatility will be more expensive than options struck on an underlying expected to be less volatile. Options therefore are a good way to gain exposure to the volatility of the underlying.

The price of volatility
The value of an option can be attributed to several components. By stripping these away, traders can imply an annualised volatility level that the option’s tick value equates to. This is known as the implied volatility. So an equity index may be trading at a certain price and it may have exhibited a certain realized level of volatility over the previous 12 months. Traders can compare this realized level of volatility with the current implied level as seen in the option market. However, there is a crucial difference here; the implied volatility level refers to the annualized volatility that is expected over the life of the option. In other words, it is forward looking and reflects traders’ current best estimate of what future realized volatility will be.