Volatility is the measure of price change -- both of the option and the underlying security within the contract. Volatility is not concerned with the direction of the change, positive or negative, but with the amount of change. Since options trading depends on the movement of price, the amount and frequency of price changes affect the risk of buying or selling the options contract. More volatility equals larger, more frequent changes in price and greater risk of the price moving against the trader.
Volatility in Options
Realized volatility is also known as historic volatility and is the actual variance in the price of an option over time. Realized volatility is measured in terms of the standard deviation of the price from an average.
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Implied volatility is the market's prediction of future volatility. In very basic terms, it can be seen as the difference between an option's theoretical price -- as calculated based on the actual stock price, the option's strike (contract) price, time to expiration and other known variables -- and the option's actual trading price.
Dangers of Exclusion
Traders can use volatility to predict risk by looking at both the historic, realized volatility and at the implied future volatility. If a trader relies solely on realized volatility for analysis, he assumes that the past is predictive of the future, an assumption that is often incorrect, especially over the short term. While studies have shown implied volatility to be a better predictor of risk in the short term, the trader who looks only at implied volatility has no context for the number. She cannot see if the implied volatility is significantly greater or less than past realized volatility and whether the option is over- or underpriced.
Comparison as Trading Tool
Option traders can use volatility comparisons as a trading strategy that capitalizes on the overpriced/underpriced theory. In this strategy, the trader buys options whose implied volatility is lower than the realized volatility and likely to rise in the near future, driving the option price up. The trader can then sell the option at a period of higher volatility and make a profit. This type of trading is like value investing in stocks: Look for a bargain, then wait for everyone else to discover its value. Allow demand to drive the price up and sell at a profit.