Last week Ron Ianieri from OptionUniversity.com came and gave us a great lesson on the misinformed traders out there and how options are a great tool (re-read it here), and today I asked him to teach us a bit about volatility and options! If you've not yet checked out Ron's new online video do it today before it's pulled.
The key to having a trade is that you, being the buyer, and me being the seller, have different volatility assumptions. What I think volatility is going to be versus what you think volatility is going to be makes the difference. Everything else we’re in total agreement with because those outputs are “hard numbers” processed by the Options Pricing Model. Current prices, selected strike price, days to expiration, interest rate and dividends are what they are. Just looking at the pricing model output based on these factors is the same for both buyer and seller. But what makes a trade is really the factor of perceived volatility. So, when we talk about volatility we are really talking about the essence of an option trade.
What is Volatility?
Basically, volatility is a measure of dispersion around the mean. A simple example would be comparing two stocks. Both have a current price of $40, however, the first stock has a price range of $15-$60 over a period of time and the second stock has a price range of $32-$52 over the same time period. The first stock is more volatile than the second stock; the range of past prices has a broader price range. Based upon historical movement, the price movement demonstrates the most probable price range. The potential outcome normally lies between the end points of the range for a certain time period.
When talking about volatility in the stock options market, there are basically four different types of volatility. The first is Historical Volatility. As Volatility has a direct link with price (higher volatility usually means higher prices) we try to predict future volatility (price) based a large part on the past history of a stock’s volatility. This leads us to extrapolate (guesstimate) the Future volatility for a specific time period in the future. This is where the art comes in. You may build your forecast on a set of assumptions different from mine. Once we input our forecast volatility into the pricing formula, the end result may be different. Differences make for perceived opportunities; you might think the option you are selling is correctly priced while the buyer feels it is under priced. However, just how much a difference in computed price may affect the actual trade is based on the individual cost-benefit perception. For example, there are times when I might feel that an option is over priced but I will buy it anyway because I think the profit potential will justify the purchase. However, for the most part, professional traders will stay away from overpriced options.
The third type of volatility is called implied volatility. We can actually figure out what your forecast volatility is by working your bid price. If you bid $3.00 and I put this into the model and solve for volatility, I can come up with your measure of volatility. This is the implied volatility as observed by your bid price. If the implied volatility for your bid is lower than mine, I am implying that I think there will be more future volatility and thus potential higher prices. Keep in mind that every time any of the variables change, so does the outcome of the pricing model.
The final volatility is future volatility. This is our “best guess” as to what we think the future volatility will be. The difference is that future volatility is not a product of the option pricing model.
Please take time and watch my free online options training video!