With the caveat that the author is often talking about going long options (in which case high volatility is bad and making the calendar spread discussion the closest thing in the article to covered call writing) I offer the following discussion of volatility:
optionetics.com
BACK TO BASICS: Monitoring Volatility’s Effects
By Andrew Neyens, Optionetics.com
9/28/2001 11:30:00 AM
In the previous article in this series (9/17/01), we looked at the six factors that make up
an option’s price, as listed below:
1. Time remaining until the expiration date of the option
2. Estimated volatility of the underlying asset
3. Risk-free interest rates
4. Size and timing of any dividends
5. Price of the underlying asset
6. Strike price of the option.
We then explored the concept of the time remaining until the expiration of the option. In
this article, we shall look at the estimated volatility of the underlying asset, and how that
affects option pricing. More importantly, we shall explore how volatility affects the choice
of our option trades.
An option’s price consists of two major parts: intrinsic value and extrinsic value. The
intrinsic portion is simply the absolute dollar amount that the option is in-the-money
(ITM); the extrinsic value is the part of the option’s price that exceeds the intrinsic
value. The price of an option that is at-the-money (ATM) or out-of-the-money (OTM)
consists entirely of extrinsic value. The volatility of the underlying asset will only affect
the extrinsic value of the option.
Volatility is a measure of the fluctuation of the price of the stock, and is measured in
percent of movement. In the Black-Scholes Option Pricing Model, the volatility is defined
as “the standard deviation of the continuously compounded return on the stock.” In
other words, if a stock has a volatility of 30, this means that historically the stock has
returned 30% (up or down – volatility is non-directional) on an annualized basis. The
volatility does not indicate which direction the stock might move, only that it has the
potential to move. Thus, if the stock that we are looking at is priced at $100, 30%
volatility means that it has an equal chance of being at $130 or $70 at the end of the
year. In fact, the stock price will be within that range two out of three years, on
average, as the volatility is calculated to be one standard deviation in size.
Using historic data for the volatility shows up its weakness. It assumes that the future
volatility of the stock (for which we are calculating the option’s price) will match (or at
least closely approximate) the historic volatility of the stock over the recent past. If there
is any fundamental change in the underlying asset, then this assumption will not hold
true. Thus, if there is some change in the fundamentals of the firm (rumor or fact), the
floor traders will “adjust” the volatility, and hence the price of the option.
Thus, the concept of implied or expected volatility is created. The assumption here is that
the option is fairly valued. Volatility can be calculated by simply using the Black-Scholes
Pricing Model that generates the volatility it takes to get to the given price. Then, the
trader can look at the implied volatility and compare it with the historic volatility, making a
decision on the correctness of the assumed volatility in the pricing of the option.
Volatility is an important component of an option’s price. It is a measure of the price
range within which the stock should remain in the next year. A higher volatility will result
in a higher option price because there is a greater chance that the underlying will move
ITM by the expiration of the option. As volatility is non-directional, both puts and calls will
exhibit these phenomena; they will both be priced higher as the volatility increases.
Two other characteristics of volatility should be noted. First, the change in option price
with a change in volatility is linear. A 10% increase in volatility will result in a 10%
increase in the option price. Similarly, a 15% decrease in volatility will result in a 15%
decrease in option price (approximately, for an ATM option). OTM and ITM options will
also change prices linearly with volatility changes, but the changes won’t be quite as
simple; the rate of change will vary by how far ITM or OTM the option is located.
The second characteristic is that the estimate of the volatility is only an estimate of the
future volatility of the underlying. This means that any change in sentiment by the
market will result in a change in the volatility estimate, and hence a change in the price of
the option.
What does all this mean to the trader? It means that keeping a close watch on the
volatility estimated for your position is critical for profitability. If you are looking at two
different stocks, and Stock A has a volatility twice that of Stock B, then Stock A’s options
should be priced roughly twice that of Stock B’s options. Hence, the return on investment
will be significantly greater in the case of Stock B if the two underlying stocks end up at
the same price. For example, if Option A costs $2, Option B costs $1 and the stock for
both A and B end up $2 ITM at expiration, the ROI for Option B will be 100% [(2-1) / 1 =
1.00] and the return for Option A will be 0% [(2 – 2) / 2 = 0.00].
If you trade straddles (simultaneous purchase of an ATM put and a call), you will be
doubling your cost and hence your return will be affected even more by the estimated
volatility used to calculate the option’s price. Either the simple purchase of options or of
straddles screams for low implied volatility. High volatility will almost guarantee that the
trader will lose money.
Spread trading, on the other hand, is not so clear. By both purchasing and selling an
option (at different strikes but the same expiration date), the effect of high or low
volatility in the pricing of these options are, to a great extent, neutralized. What you are
looking for at that point is the probability that the underlying will actually end up ITM at
expiration. If you are trading low-risk spreads (i.e. buying a spread where the options
are already ITM), then you want a low volatility stock. You don’t want the stock to move
downward such that your spread ends up OTM by expiration. On the other hand, if you
were initiating the spread with the option’s strikes OTM (higher risk position, but
potential for much greater returns), then you would be looking for a stock with the
potential to move dramatically—a high volatility. The idea is that you want the underlying
to end up in-the-money by expiration (stock moving up if you are bullish and down if you
are bearish).
If you are trading call or put ratio backspreads (long more options than you are short),
you again want a low volatility entry point. You are in a net long position, so high
volatility would result in a higher price (thus lowering the return) than would a low
volatility position.
The final type of trade is a calendar or diagonal Spread—the simultaneous purchase and
sale of options with different expiration dates. The implied volatility of options with
different expiration dates will frequently differ, with the near-term option (the one you
are short) having greater volatility. Volatility traders look for a skew (or difference) in the
volatility between the near-term and far term options. According to the theory, the
greater the skew difference, the better the trade (regardless of the absolute value of the
volatility). The idea is that since the near-term option has been sold, it will lose value
faster than the long-term option and the greater the difference between the two, the
greater the potential profits.
However, there is another truism in trading, and that is that prices tend to return to the
mean. This means that if the volatility of the long-term option is higher than normal, it
will tend to drop back to normal values over time. If the long-term option is also losing
volatility as the short-term option is expiring, the corresponding drop in price of the
long-term option may be great enough to erase any potential profits in the trade. The
solution to this problem is to purchase a long-term option only if its volatility is relatively
low historically, regardless of the volatility of the short-term option. This would give a
boost to the value of the option if its implied volatility increases to its normal levels, and
reduce the probability that the option would lose volatility (it is already low compared to
it’s norm).
In general, then, we are looking for low implied volatility to enter most of our trades. If
we are faced with high volatility, then we should be looking to enter a trade where we
are both buying and selling equal numbers of options that expire simultaneously. This
will give us the best chance to minimize the negative effects of volatility in our trading.
Where can you find the volatility of your options? Obviously the Optionetics Platinum site
has both the instantaneous volatility as well as the historic volatility of the stock’s
options. Your broker will have the volatility figures. There are numerous computer
programs containing the Black-Scholes Model that will calculate the value for you. These
programs are frequently included with a text on options. Check your local university’s
business school for the texts they are using. However, remember that you are looking
for the option’s volatility in relationship to its historical values, not some absolute
number. Low volatility on an eBay option will be a much higher absolute number than a
correspondingly high volatility would be on a stock like Motorola. You want to be sure to
check any volatility figures against the historic norm for the stock.
Volatility is a key component of the price of an option. It is not an “absolute,” but rather
an estimate of where the market (and ultimately the trader) thinks the underlying stock
will be priced over the next year. By watching the volatility built into the option price, and
trading accordingly, the astute trader can gain a small, but potentially significant
advantage in setting up profit making trades.
Andrew Neyens
Senior Writer &Trading Strategist
Optionetics.com ~ Your Options Education Site |
