7. The Many Facets of Volatility

The term "volatility" is often confusing because it's used in many different ways. Perhaps some of the following statements will help clarify some of the issues about volatility:

1. Statistical volatility (SV) measures the magnitude of historical moves (regardless of direction) in an underlying futures contract.

2. SV can be computed over time periods of varying lengths. And SV over a 30-day period will likely be different than SV over a longer or shorter period.

3. Do not confuse volatility with trending behavior. They are separate from one another. A trending market may have a low SV while a volatile market may be non-trending.

4. Implied volatility (IV) measures options traders' expectations for statistical volatility. The higher the IV, the higher the options prices will be. The lower the IV, the lower the options prices will be.

5. Each option has its own IV. Each commodity can be said to have a composite IV (consisting of a weighted average IV).

6. Some commodities exhibit seasonal volatility patterns.

7. A market possesses a positive volatility skew when out-of-the-money calls carry a higher IV than out-of-the-money puts. A market possesses a negative volatility skew when out-of-the-money puts carry a higher IV than out-of-the-money calls.

8. IV is generally stated in terms of an annualized standard deviation. So, for example, if IV is 10%, it means there's a 68% expectation that one year from now, the underlying futures price will be in a range defined by prices 10% above and 10% below today's price.

9. Options on a commodity are considered to be overvalued if its composite IV is greater than SV. They are also overvalued if current IV is higher than historical IV.

10. Options are considered undervalued if its composite IV is less than SV. They are also undervalued if current IV is less than historical IV.

11. Changes in IV directly affect options prices. Increases in IV cause higher options prices and decreases in IV cause lower options prices.

12. Forecasting IV is always important unless your trade horizon is option expiration date. In that case, SV is important.

13. IV tends to revert to its long term average. So a statistical edge is created by selling options in markets exhibiting high IV and by buying options in markets with low IV.

"Knowledge is power and all traders can benefit by continually bolstering their knowledge base. I hope to contribute in that regard."  Paul Forchione