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Volatility
Volatility is one of the most important factors in an option's price.
It measures the amount by which an underlying asset is expected to
fluctuate in a given period of time. It significantly impacts the price of
an option's premium and heavily contributes to an option's time value. In
basic terms, volatility can be viewed as the speed of change in the
market, although you may prefer to think of it as market confusion. The
more confused a market is, the better chance an option has of ending up
in-the-money. A stable market moves slowly. Volatility measures the speed
of change in the price of the underlying instrument or the option. The
higher the volatility, the more chance the option has of becoming
profitable by expiration. That's why volatility is a primary determinant
in the valuation of option’s premiums. There are options strategies that
can be used to take advantage of a high volatility or low volatility
environment.
On the first Friday of each month, the government releases the
employment report. As soon as the report is released, a fluctuation in the
bond market usually occurs. This produces a simultaneous reaction in many
stocks as their volatility increases. If a market's volatility was sitting
just below 10, perhaps it is at 15 after the release of the report. You
can equate that 5-point rise to an approximate 17% increase in an option’s
price even if the price of the underlying stock doesn't move anywhere.
Afterwards, volatility usually reverts to its normal levels. Driven by
volatility swings, event-driven situations offer profit-making
opportunities if you know how to take advantage of them. There is a
general rule of thumb: buy options in low volatility; sell options during
periods of high volatility. Markets with lots of volatility trigger an
inflation of option prices. A market that moves a lot increases the
probability that an option on that stock will end up in-the-money.
There are two basic kinds of volatility: implied and historical.
Historical volatility is calculated using the standard deviation of
underlying asset price changes going back a set number of days. Implied
volatility is a computed value that measures expected volatility and is
partially based upon historical volatility. The theoretical fair value of
an option is calculated by entering the historical volatility of the
underlying asset into an option pricing model (i.e. Black-Scholes for
stocks). This value may differ from its actual market price. Implied
volatility is the volatility needed to achieve the option's actual market
price. In more basic terms, historical volatility (also called statistical
volatility) gauges price movement in terms of past performance and implied
volatility approximates how much the marketplace thinks prices will move.
Volatility is a very important piece of the puzzle, not only for analyzing
an option's value, but for assessing a market's inclination for dramatic
price movement.
In its most basic form, volatility means change. Implied volatility is
best calculated with the aid of a computer that can easily apply current
market prices in the model. This process provides the trader with market
consensus for expected volatility in the future.
A trader can gain quick insight to a stock's historical volatility by
looking at its price range; the bigger the range, the higher its
volatility. The formula for calculating historical volatility is somewhat
complex; however, an approximate value can be obtained by using the price
range for a stock over a relatively short period (anywhere from 10 days to
12 months). To determine a stock's historical volatility, calculate the
equilibrium level (midpoint) of a stock's price range. Then simply divide
the difference between the high point and the equilibrium level by the
equilibrium level to get the volatility percentage. For example, Microsoft
Corporation has been fluctuating between 22 (support) and 28 (resistance)
for the last year. The equilibrium level is 25 [(28-22) / 2 = 3 and 28-3 =
25]. Microsoft's approximate volatility is 12% [3 / 25 = 12%]. This
percentage can then be used to forecast the maximum price action a stock
is likely to make throughout the next 12 months.
Examining the difference between a stock's historical volatility and
implied volatility can also help traders to recognize when a stock option
is underpriced or overpriced. If the option's implied volatility is higher
than the historical volatility, the option is theoretically overpriced.
Option sellers look for these kinds of opportunities to sell high and buy
low. In contrast, option buyers look for underpriced options by searching
for market situations in which the implied volatility of an option is
lower than the historical volatility (buy low and sell high). You may
choose to spend a lot of time screening markets to determine their
volatility. In general, there are two very different kinds of markets. The
first one has plenty of movement, and high volatility. The second market
has very low volatility. In general, sell options with high volatility and
buy options with low volatility.
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