This article is from the Investing Articles: Stocks and Options series.
Volatility is the key to trading options effectively. This is because volatility is a primary determinant of an option's price. So what is volatility? Volatility is a measure of the degree of change in a stock's value stated as a percentage over one-year. Mathematically, volatility is a one standard deviation price change, in percent, at the end of a one-year period.
Simply stated, a high volatility means that the stock, index or future has a very good chance of moving big. A low volatility stock, index or future has a very good chance of not moving much at all! Let's say a trader has bought a call option on a stock. The trader wants the stock to go higher as quickly as possible. An indication of the likelihood of the stock going higher (or lower) is the volatility. The higher the volatility, the better the chance your stock will jump higher, and hence the better the chance the call option will be worth more in the future. If an option has a good chance of being worth more in the future, it usually costs more to buy it now.