Volatility is simply the measure of how much prices move over a given period of time. It’s most often calculated by finding the standard deviation of open and close prices for that period of time.

It can also be calculated other ways like finding the average size of high-low ranges over a period of time, or other similar methods.

More important than how it’s calculated, is how it’s used. And the folks who use volatility the most are option traders.

In fact, if you are trading options, you are explicitly making volatility bets more than anything else.

And whether or not you trade options, I think every retail trader needs to know how the model that drives option trading is used.

Because if you can understand how this model targets the volatility of a distribution, and takes advantage of the fact that it’s not perfectly normal, you can understand how you can build a strategy that can target other characteristics of the distribution.

The Option Model

Whenever you buy an option, the first thing you need to know is, are you getting a fair price. At first glance, trying to figure out what a fair price would be seems daughnting, but by the time we are doing explaining how it’s calculated, it will make sense to you.

So in order to figure out a fair price for the option, you need to have a good understanding of the underlyings distribution. Since price distributions can appear normal in a lot of ways, most option traders will assume a normal distribution when calculating an option price.

As part of this assumption, one thing they need to estimate is the volatility of the distribution, often referred to as it’s standard deviation. And it’s important they get this estimation correct, otherwise they will either buy or sell the option at a bad price.

Once they have their estimate, they essentially calculate all of the possible paths price could take for this options duration, and average together all of the option’s payoffs. This average, is the “fair price” of the option.

So if you are buying this option, and everything remained equal, you can expect to make exactly what you paid for the option over time.

This means as an option buyer, whether it’s a call or a put, what you really are wanting to see overtime is higher volatility than what was used to calculate the options price.

If the volatility is higher than what was used to calculate the original price, then more price paths would close above the options strike than originally estimated, and they would close higher above the strike than originally estimated.

This would raise the average of all possible payoffs, and the difference between this new average and the original one used to price the option, is your profit.

So in this model, the edge is in understanding volatility. This is where all of your risk and reward will come from. And the general idea/advantage of this model is, volatility is easier to forecast than price.

You want to buy when it’s low, making the prices of options cheap, with the idea that it will be higher than what was used to calculate it’s price.

The Big Picture

It’s important to make sure you completely grasp what is being described in this lesson, specifically the bigger picture of it.

The point of describing the option model is highlight what is going on at a higher level. And that is:

1. A model is created around an assumed price distribution in order to calculate the average return or “fair value” for that model. This is your f(x) and in this example, it’s the process used to calculate the price of the option.
2. As part of that calculation, you isolate certain aspects of the distribution that are easier to forecast than the distribution itself, that will impact the accuracy of that “fair value” estimation. This becomes x and in this example, it’s volatility.
3. You then understand how changes in x impact your f(x) payoff, and trade based on x instead of trading price directly.

These are the core steps that must occur in order to build any profitable trading model. If you are creating a strategy, and can not clearly illustrate how what is described in the steps above is happening, you won’t have one that works.