chapter4/5 identifying unusual volatility

Identifying Unusual Volatility

How can options trading at a high volatility be identified? There are well established methods for computing implied volatility, but there are different interpretations of what constitutes unusual volatility. The motive for identifying unusual volatility determines the method for identifying it.

• A vertical spread trader must examine the chain of options for a specific expiration date looking for disparities in implied volatility. A bull call or bear put spread trader will look for near the money options with a higher volatility than the leg that is further out of the money, since the sale of this leg will be used to discount the purchase of the leg that is closer to the money.

  A bull put or bear call spread trader will look for trades where the in the money option has a higher volatility, since this leg is sold in anticipation of the stock moving in a certain direction. Spreads tend to be more profitable when the volatility on the short leg is higher than the volatility on the long leg. The Vertical Spread Screener can help identify spreads that meet this criteria.

• similarly, a horizontal spread trader must examine options with different expirations and the same strike price, looking for short term options trading at a higher relative premium than the long term option. Horizontal Spread Screener.
• A stock trader may measure the change in option volume or volatility for an option or option chain as a signal of a potential change in the stock price. Open Interest.
• an even more sophisticated approach is to examine changes in the relative put versus call volume to gauge the market sentiment of a position, typically referred to as the put call/ratio. The put call ratio can be computed based solely on volume, or an extended algorithm can be used to compute the relative dollar volume of puts vs. calls. The Strike Pegger analyzes the relative put/call dollar volume of all options for selected stocks.\

Complex option strategies such as spreads and straddles are discussed in Chapter 5.