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Gold/Mining/Energy : Big Dog's Boom Boom Room -- Ignore unavailable to you. Want to Upgrade?

To: Bocor who wrote (182353)	1/27/2014 3:31:09 PM
From: Mark Mandel	Read Replies (1) \| Respond to of 206184

<<High premiums are always associated with high volatility, no?>> There is a correlation.

To: Bocor who wrote (182353)	1/27/2014 6:26:54 PM
From: Biomaven	2 Recommendations Recommended By Bruce L chris714 Read Replies (1) \| Respond to of 206184

>>High premiums are always associated with high volatility By definition. The price of an option (whether a call or a put) is driven by the strike price compared with the current stock price, the remaining term on the option, the projected dividend, the expected volatility and current risk-free interest rates. All those are essentially known except for the expected volatility. Because of the above relationship, if you know the price and terms of an option you can solve for the volatility that produces the right price. That is termed the implied volatility ("IV") of an option. Some sites (e.g. Fidelity) will show you the implied volatility for an option chain. There is one complication - the implied volatility is calculated using Black-Scholes, which in turn assumes stock price returns are log-normally distributed. In fact they are not - they have fatter tails, meaning extreme events are more common than for a true normal distribution. To compensate for this, you will see that the implied volatility differs for different strike and expirations. Basically options with short expirations and options that are well out of the money will have higher prices than you would expect because of the chance of a sudden move in the stock. Thus the implied volatility will be higher for very short-term options and options that are out-of-the-money. This phenomenon is called the volatility "smile" or "smirk." An option trader will think of the price of an option purely in terms of the IV. Similarly sites that allow you to buy non-traded warrants will quote prices in terms of IV only. Don't confuse the IV with the historical volatility. The first is a forward-looking number; the other is a backward-looking number showing what the actual volatility of a stock has been over some historical period. Peter