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Share traders will generally look to profit from short term price movements in the underlying share price. The individual trader will use analytical and technical tools to determine how best to predict future movements in the share price.

Similarly an option trader will generally also have a short term focus as the majority of trading in the options market occurs within months, i.e. the following 3 months. In addition to traditional indicators used by share traders, an option trader may also consider other factors in their analysis of future price movements.

Option traders will commonly evaluate the volatility of the underlying share – volatility measures the size and frequency of price movements. From an option trader’s perspective the volatility calculated into the price of an option is particularly relevant as they will want to buy options when volatility is low and sell options when volatility is high.

We can hypothesize that high volatility translates to a perception by the market there will be greater uncertainty of future price direction. However this analysis alone does not tell us in which direction the market anticipates the share price will move, only that the price movements are expected to be large.

An option trader may therefore compare the volatility of call options against that of put options. If it is found there is a variance in the volatility figure between call and put options on a relative basis, then the trader can conclude the market anticipates the underlying is more likely to move in one particular direction, i.e. an upward movement when volatility is high for calls, and a downward movement when volatility is high for puts.

During August this year high levels of volatility were evident in the equities market stemming from events in the U.S. Similarly in the options market there were high levels of volatility being priced into put options in comparison to that of call options. This would indicate the market had a bias towards a fall in equity prices – put option buyers were prepared to pay higher option premiums (for the probability of a fall in the underlying), and put option sellers needed compensation commensurate with the added risk.

An option trader may also look at what is known as the Put Call Ratio – a measure of the number of put options traded in comparison to the number of call options traded. This provides an indication of whether the options market is bullish or bearish based on the trading volume of call and put options, i.e. a ratio greater than 1 is a bearish signal, and a ratio less than 1 is a bullish signal.

The more information a trader can digest the better they will be informed when it comes to making trading decisions. Although the indicators discussed may further assist a trader in basing their decisions on which way share prices will move, they are not always correct and cannot be considered to be conclusive.

By Matt Comyn, General Manager, CommSec

Disclaimers: The views expressed in this article are those of Matt Comyn, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 and is not intended as general advice.