The volatility of the financial markets is pivotal to the success of binary options traders. Simply put, volatility measures market movement over a period of time. For the most part, volatility is measured on an annualised basis of daily movements in the market. Advanced binary options traders typically refer to 2 types of volatility in the market: historical volatility and the implied volatility. Implied volatility seeks to address the question of market movement in the future. Volatility is used to price options and it is essentially the market’s perception of price movement with a financial instrument. It should be pointed out that implied volatility is based on supply/demand, greed and fear. This market-based measurement will also fluctuate according to market sentiment.
Implied Volatility and Historical Volatility
Volatility can be calculated and extrapolated onto implied and historical volatility charts for specific instruments, including: stocks, indices, commodities and currency pairs. When volatility levels are high, traders tend to consider selling their options, owing to the fact that the prices of premiums on those financial instruments will be higher. When volatility is low, traders will contemplate purchasing options. So the general rule is to always buy options when volatility is low and sell options when volatility is high, with price considerations in mind.
The other type of volatility that binary options traders tend to watch is historical volatility. Historical volatility measures how much a financial instrument has moved over time. It does not project into the future like implied volatility does. Recall that options are priced according to a number of factors. These include the strike price of the option, the price of the underlying security, current interest rates, time to maturity and others. The probability that the financial instrument will move a specific distance over X amount of time is measured by implied volatility. When implied volatility increases, the price of the option will increase.
Characteristics of Volatility in the Financial Markets
Highly volatile markets are characterised by major swings, making them considerably more unstable. By contrast, a stable market is characterised by low volatility, with prices in a tight range. Advanced binary options traders and intermediate level traders prefer highly volatile markets as there is greater profit potential. Additionally, the return on investment can be more significant, but the risk of inaccurate assessment of market conditions is equally great. Volatility should always be factored into the equation when you are applying binary options strategies.
It should be pointed out that highly volatile conditions may be a pretext for a correction or a reversal in market conditions. When the market is highly volatile, it should be borne in mind that it will return to an average range of volatility at some point. In economic terms this is known as regression to the mean. The flip side of the coin is that markets characterised by prolonged periods of low volatility are more prone to a breakout where sharp increases or decreases in volatility will ensue.