The Chicago Board Options Exchange is expanding the tools you can use to anticipate future volatility. Already, the CBOE disseminates information on the anticipated volatility for broad-based stock market indices, oil, gold and, as of early this year, a select number of individual stocks. Financial advisors who understand how to use these instruments can enhance their role with clients — particularly when positioning specific recommendations.

Investment decisions hinge on the potential for an underlying security. Simply stated, you buy a stock to exploit a positive view and sell the stock if the outlook is negative. However, such recommendations take into account only the stock’s potential — without really looking at the risk side of the equation. Being able to quantify the risk goes a long way toward helping your clients make informed decisions — and that’s where implied volatility indices can help.

When we talk about “implied volatility,” we are really talking about an implied trading range — the market’s best guess as to the upside potential and downside risk associated with a security.

Take Apple Inc. (recently priced at US$341 a share) as an example. Apple is one of the stocks that the CBOE is using to disseminate volatility information. At the time of writing, Apple options were implying 32% volatility.

To make use of this information, we need to understand that 32% implied volatility is an annual volatility number. If you add 32% to Apple’s current price, you get an upside trading range of US$450. Take the same current price, subtract 32% and you arrive at a downside price of US$232. Statistically, US$232-US$450 is the annual implied trading range for Apple, as defined by options traders.@page_break@Volatility calculations are tied to a “log-normal distribution” (a calculation found in probability theory) for the stock price, implying a slight bullish bias to the calculation. This effectively raises both the upside and downside range. But, for this discussion, a loose calculation will suffice.

Now, suppose you want to recommend Apple shares to a client. You begin with a target price and timeline. If you think Apple could hit US$400 within the next six months, you issue a “buy” recommendation. But how does that target price fit with the market’s view of the risks associated with Apple?

The first step to quantifying the risk is to establish an implied trading range for the next six months. To do that, we first must translate the 32% annual volatility to a six-month number, which requires multiplying the annual implied volatility by the square root of time — in this case, of six or 12 months. The resulting implied volatility for six months is 22.6%, which loosely implies a six-month trading range of US$264-US$418.

This range is not a foregone conclusion; it is simply what the market believes, statistically, is a reasonable trading range for Apple shares — representing one standard deviation up or down — over the next six months. Put another way, the downside risk is US$264.

Taking this process a step further, you could argue that an implied trading range based on the current price doesn’t really define the risks associated with the underlying stock because it assumes the current price is fair.

Technicians might say that the current price has less value than the trend for Apple, leading some to put more weight on a moving average. For example, if we used the 50-day moving average to determine a fair price for Apple, that price would be US$320 a share.

Now, if we frame the 50-day moving average with the same trading range implied by the six-month volatility calculation, we get a range of US$248-US$392.

On that basis, downside risk from the current price level is greater than upside potential. This info might be useful in determining the point at which you would set a tighter stop-loss price. IE