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We ve outlined some of the major changes in market participation in recent years with the growth of new markets, changes in market participants, and the basics of options The last decade brought new meaning to the term volatility in markets around the world with new standards of price movement and volume This new volatility has affected nearly all sectors from agriculture and energy to equity and nancial markets To manage market volatility in your portfolio, it is important to understand the basic cause of market volatility and its effects In this chapter we discuss volatility and what it means to successful trading and managing risk now and in the future

Volatility is de ned as the measure of instability in the price of a security instrument Simply said, volatility is the measure of price

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movement risk on a particular stock, future, or other security The higher the volatility of the instrument, the greater the assumed risk of signi cant changes in price over a period of time This often correlates to direct risk, in that if the price change is dramatic, the risk of the price being contrary to your position increases What makes studying volatility important in your portfolio is the understanding of the risk you are undertaking with a particular position or group of positions both now and in the future We can break volatility in to three common indicators current, historical, and implied

Current volatility is the measure of the active volatility of a position Current volatility can be calculated with the standard deviation, most often a 20-day period Figure 31 shows the 20-day standard deviation volatility chart for Home Depot Corporation

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You can see in the gure that Home Depot experienced a spike in volatility in October 2008 which reached up to over 90% Remember, volatility is an indication of the range of movement in the stock price and the average risk of the price based on the period selected In this case we used the standard deviation at 20 days If you look at the chart in Figure 32 you can see that the volatility is not necessarily an indication of market direction as Home Depot stock fell sharply during the rise in volatility

Historical volatility is the pattern of current volatility over a span of time As referenced above, current volatility is actually a short-term historical average; however, historical volatility gives an accounting of the price movement and risk of a particular instrument over a longer period and makes it possible to better project the future risk of the instrument This historical volatility is in no way a guarantee of future risk or volatility to a market, but it is a baseline that makes it possible to see unusual patterns in the future The instrument could have signi cantly higher or lower levels of volatility which may be outside the investment objectives By looking at historical volatility, we get a sense of suitability in relating the instrument to the objective In Figure 32 we can see the result of the volatility in Home Depot stock over a period of time We can see that Home Depot s stock in the center area of the chart began experiencing wide daily and weekly price swings as well as a signi cant change in trend If you have access to historical volatility charts through your brokerage house or data service, you may nd them a helpful trading tool along with your analysis of price charts Remember the wider the

average price range swings on a daily basis, the higher the volatility will be over a period of time

Implied volatility is the forward looking volatility indicator Implied volatility is related mostly to options, but can be on other securities as well Implied volatility is the measure of sentiment regarding a particular option and its underlying security or a group of options and securities in the case of index options You can think of implied volatility as a measure of investor fear and anticipation regarding the future price of an option Implied volatility is derived from the option premium versus the underlying price and the time remaining In today s world implied volatility is calculated most often with software applications rather than with pencil and paper Implied volatility is one of the most