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Volatility

Most traders are accustomed to viewing option volume through the put/call ratios.  But is the ratio really the relevant number we should study Maybe it is just the shear volume that matters. 

Let us explain:
By assessing the proportion of option volume going into put options vs. call options we try to gauge the sentiment of the market.  However suppose we were to simply look at option volume itself as the barometer to measure the degree that traders are attempting to capitalize on volatility.  Some of these traders are selling volatility to hedge against adverse market movements. Other participants are volatility buyers speculating that premiums will expand or just looking for a cheap way to play the anticipated shortterm market movement.  When option volume is high relative to its recent norms we know that many traders are attempting to profit from the volatility in the market; when option volume is relatively low there is less interest in trading volatility. In other words option players expect the market or stock to be flat for sometime.  Options traders need volatility if they are to make money stocks need to move in either direction and if they are correct and that means volatility for the stock or market.  

Why is this important When option volume is high we know that the market has mispriced the underlying stock.  Market participants are expressing conviction that the market is wrong and that they can exploit this inefficiency.  Conversely when option volume is low we know that the market has correctly priced the underlying stock and therefore there will be less movement in the stock or overall market as a result of the correct pricing.  When there is low volume in options traders are telling us the market is correctly priced and we can expect less movement (less volatility) in stocks. 

The moral of the story is that there is an active market in volatility just as there is an active market in Stocks Treasuries and Commodities.  The novice trader does not view volatility as a separate market with its own patterns trends and activity. The professional trader does and knowing how volatility is moving and how aggressively it is being traded provides relevant clues as to future stock and market movement.  Volatility will not predict the direction of a market move like the Put//Call ratio will but it can be used to try and predict the size of the move ahead.







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