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Understanding Price - Volatility

We have mentioned this term often because it is very important in the determination of the time value component of an option premium price. In its most simple form, volatility measures how much the underlying security price is likely to change, regardless of direction, over a one-year period. If you remember your high school math you probably know this is the same definition for a standard deviation.

If you would rather forget high school math let's look at volatility in another way. If a security has a volatility of 30 percent we should expect that stock to be trading between a range of $70 and $130, 68 percent of the time. You are probably thinking how did we arrive at the 68 percent figure? Without getting too far off the wall, the probability of a normally distributed value like the future stock price should be within plus or minus 1 percent of the standard deviation of the mean deviation.

The more volatile the underlying security, the greater the chance the corresponding option will move into the money. As a result, option writers (sellers) demand more time value for options with higher volatility.

For the sake of simplicity, volatility is expressed in percentage terms without regard to direction. This is often a very hard concept to grasp for most investors so think of it this way, volatility is like a swirling wind – it is important to know how strong the wind is blowing but measuring the direction is useless.

Three Types of Volatility

If you are going to use advanced hedging strategies it is important to differentiate the various types of volatility because they play an important part in option premium pricing. There are three distinctly different types of volatility. These concepts are a little tough to grasp but it is imperative that we have a firm understanding before we can tackle the next set of lessons.

Historic Volatility

Historic volatility, sometimes called statistical volatility is a measure of actual price changes during a specific time period in the past. From a mathematical standpoint, historic volatility is the annualized standard deviation of daily returns during a specific period (there is that high school math again). It is normally calculated using a 20 day moving average and can be used to help to predict the future moment of the market. Theoretically historic volatility should not matter, after all, past volatility should not be indicative of future volatility but historic measures play an important role in most option pricing models.

Why are option pricing models important? Unlike stocks, most option contracts offer very little liquidity because it is a specialized market. To help market makers set good markets most will use standard option pricing models and historic volatility is one of the key components in the formula used for calculating value.

Expected Volatility

This is a trader's forecast of volatility used in an option pricing formula to estimate the theoretical value of an option. Many option traders study market conditions and historical price action to forecast volatility. Since forecasts vary, there is no specific number that everyone can agree on for expected volatility.

Implied Volatility

For any option that has a quote, it is possible to determine the volatility from the option's price. It's volatility implicit in the price, or in other words an implied volatility. This is a tough concept so let's take a moment and think about this from a different perspective.

Previously, we noted that the volatility was an input parameter to determine the fair value. Well, if you assume the options quote is the fair value, you can then determine what volatility has been "implied" in the price. This is the implied volatility.

Implied volatility is a precise number that professional option traders need to know to decide if an option is overpriced or under priced. Just looking at the price of the option is not sufficient. An in- the- money option can be very expensive but still be cheap when volatility is considered. This is particularly evident when it comes to the option pricing for Internet and technology stocks.

When you really think about it, implied volatility is what option traders believe the statistical volatility will be before the expiration of the option.

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