The concept of option volatility is one of the most little understood and under utilised in option trading. But knowing about it can make all the difference to the profitability or otherwise, of your trading decisions. It should also be very influential in the type of trades that you decide to put on.
What is Volatility?
Volatility, as the name implies, is a measure of the range in which a stock price is expected to travel during a given timeframe. Sometimes stock prices appear to hover within a tight range for a while, in which case you would say that the short term volatility is low. But then a price breakout comes and a strong directional movement occurs, at which time you would say that volatility has increased.
The trick is to determine whether there is any correlation between the price volatility of the underlying financial instrument over a given period, known as the “Historical Volatility” (HV) and the volatility that is implied in its associated option prices. Where a disparity occurs, it often presents trading opportunities.
Essentially, before we place an option trade we need to decide whether the option contract we’re looking at is over-priced or under-priced – and the way we do this is by analyzing what is known as the “Implied Volatility” in the option price. If we decide that the option is going for a bargain because the Implied Volatility (IV) is low, then it presents a great buying opportunity. On the other hand, if the option is considered expensive we would probably avoid going long and look at option trading strategies such as spreads involving “sell to open” positions.
Unlike futures and CFDs, option prices are rather complicated affairs. You may have heard of the Black-Scholes or the American Binomial option pricing models. These are mathematical formulas which take into account the current market price of the underlying stock in relation to a relevant option strike (sometimes called ‘exercise’)price, plus the number of days to option expiry, in order to calculate a theoretical price for the option contract. If the current bid-ask price of the option is above the theoretical price then we would say its Implied Volatility is high. Conversely, if the price is below the theoretical price then the IV is low.
Implied Volatility thus becomes two things.
1. A premium or discount above or below the theoretical fair value of the option.
2. An indicator of anticipated future price volatility of the underlying stock, usually determined by the market maker.
The other factor that must be borne in mind in order to give the IV some meaning, is the Historical Volatility of the stock itself. Both the HV of the stock and the IV of the option are expressed as a percentage and should be compared before entering a trade. Historical Volatility is basically a stock’s price movement either side of an average over a predetermined number of historical trading days.
Let’s say you’re looking at a stock in an upward trend and want to take a call option position following a pullback. You would have a choice of “in the money” (ITM), “at the money” (ATM) or “out of the money” (OTM) strike prices. As you compare the call option prices for each strike price, you may notice that the OTM options are over-priced compared to the ATM prices. This being the case, you would not want to be buying the OTM options, even though they may appear a little cheaper. You should either ‘buy to open’ the ATM options or even take out a Bull Call Spread because the OTM sold options would give you a greater credit and make your overall position cheaper, thus giving you an advantage.