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Thursday November 20, 2008 |
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.
factors
effecting premium 
the
option greeks
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Volatility
