Mathematically, volatility is a measure of stock price fluctuation without regard to direction. Specifically, volatility is the annualized standard deviation of daily percentage changes in a stock's price.
Most individuals intuitively understand that volatility relates to price movement, and this intuition is correct. If a stock has a 12 month high of $120 and a 12 month low of $80, it is more volatile than one that traded between $95 and $105. Over a shorter term, a stock with an average daily trading range (high to low price) of $5 is more volatile than one that has an average daily trading range of $2 (assuming the average underlying price of both stocks are the same).
If you review historical prices of stocks as we all do, you'll notice that individual stocks go through periods of high and low volatility. There are many explanations for these variations. One might be general economic factors affecting an industry group of stocks. Another might be specific developments for the specific stock. A third possibility could be the psychological state of investors. Irrespective of the cause, threaders who use options as an investment must be aware that the volatility characteristics of a stock can change dramatically at any point in the future.
The relationship between volatility and option prices is a direct one: as the volatility percentage increases, so do option prices. A higher standard deviation means that greater movement is likely, and greater movement justifies higher option prices. Although the relationship between volatility changes and option prices is nearly linear, it is a different line for in the money, at the money, and out of the money options.
You've got to remember that option prices are based on the expected volatility of the underlying stock. And that mathematically, volatility is non-directional. If the market expects greater fluctuation in a stock's price, the fluctuation could be up or down. As a result, when higher volatility is expected, both call and put prices rise.
In circumstances where there is an increase in expected volatility, at the money options increase in price more than out of the money options because of how price movements are distributed according to probability theory (Bleaachhhhh!)
But mathematically, a $50 stock always has a greater probability of moving $1 than of moving $6. This explains why at the money options have higher prices than out of the money options. Also, according to probability theory, an increase in the level of volatility increases the likelihood of a $1 move than the likelihood of a $6 move. Hopefully, this explains why at the money options increase more in price than out of the money options when the expected volatility increases.
What to option MM's do? They look at implied volatilities. This number, of course, is based on the theoretical value of some estimated "fair market value" for an option, derived from a mathematical model similar to Black & Scholes. MM's, using this model or others, recognize that the price at which an option is trading tells what volatility level in the stock is implied by the options price. When they observe that volatility is significantly higher than normal, MM's sell the options and usually hedge by buying or selling stock.
Obviously, for professional floor traders who trade large numbers of options and manage large open positions, differences between actual stock price volatility and the implied volatility of options can have a material impact. But for off-floor users of options, the differences in implied volatility and recent actual volatility rarely are significant - as long as they know the actual volatility at which options they are trading are priced.
For most threaders, stock selection, the timing of price movements, and the desired rates of return are the most important considerations.
If it's any consolation Freeus, forecasting volatility seems to be an insurmountable task to the average investor. It's really analogous to forecasting the weather: even though technology has been continuously developed and redefined, weather predictions involve judgment and, as you know, are not always accurate.
Ultimately, you've got to make a subjective decision about volatility. Certainly, your experience in Dell and keeping up with the latest market conditions is a great help.
And now, have a virtual martini on me for reading this unintentionally dry post. Cheers!
Best regards,
Mark A. Peterson |
