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Volatility

Volatility is one of the most important factors in an option's price. It measures the amount by which an underlying asset is expected to fluctuate in a given period of time. It significantly impacts the price of an option's premium and heavily contributes to an option's time value. In basic terms, volatility can be viewed as the speed of change in the market, although you may prefer to think of it as market confusion. The more confused a market is, the better chance an option has of ending up in-the-money. A stable market moves slowly. Volatility measures the speed of change in the price of the underlying instrument or the option. The higher the volatility, the more chance the option has of becoming profitable by expiration. That's why volatility is a primary determinant in the valuation of option’s premiums. There are options strategies that can be used to take advantage of a high volatility or low volatility environment.

On the first Friday of each month, the government releases the employment report. As soon as the report is released, a fluctuation in the bond market usually occurs. This produces a simultaneous reaction in many stocks as their volatility increases. If a market's volatility was sitting just below 10, perhaps it is at 15 after the release of the report. You can equate that 5-point rise to an approximate 17% increase in an option’s price even if the price of the underlying stock doesn't move anywhere. Afterwards, volatility usually reverts to its normal levels. Driven by volatility swings, event-driven situations offer profit-making opportunities if you know how to take advantage of them. There is a general rule of thumb: buy options in low volatility; sell options during periods of high volatility. Markets with lots of volatility trigger an inflation of option prices. A market that moves a lot increases the probability that an option on that stock will end up in-the-money.

There are two basic kinds of volatility: implied and historical. Historical volatility is calculated using the standard deviation of underlying asset price changes going back a set number of days. Implied volatility is a computed value that measures expected volatility and is partially based upon historical volatility. The theoretical fair value of an option is calculated by entering the historical volatility of the underlying asset into an option pricing model (i.e. Black-Scholes for stocks). This value may differ from its actual market price. Implied volatility is the volatility needed to achieve the option's actual market price. In more basic terms, historical volatility (also called statistical volatility) gauges price movement in terms of past performance and implied volatility approximates how much the marketplace thinks prices will move. Volatility is a very important piece of the puzzle, not only for analyzing an option's value, but for assessing a market's inclination for dramatic price movement.

In its most basic form, volatility means change. Implied volatility is best calculated with the aid of a computer that can easily apply current market prices in the model. This process provides the trader with market consensus for expected volatility in the future.

A trader can gain quick insight to a stock's historical volatility by looking at its price range; the bigger the range, the higher its volatility. The formula for calculating historical volatility is somewhat complex; however, an approximate value can be obtained by using the price range for a stock over a relatively short period (anywhere from 10 days to 12 months). To determine a stock's historical volatility, calculate the equilibrium level (midpoint) of a stock's price range. Then simply divide the difference between the high point and the equilibrium level by the equilibrium level to get the volatility percentage. For example, Microsoft Corporation has been fluctuating between 22 (support) and 28 (resistance) for the last year. The equilibrium level is 25 [(28-22) / 2 = 3 and 28-3 = 25]. Microsoft's approximate volatility is 12% [3 / 25 = 12%]. This percentage can then be used to forecast the maximum price action a stock is likely to make throughout the next 12 months.

Examining the difference between a stock's historical volatility and implied volatility can also help traders to recognize when a stock option is underpriced or overpriced. If the option's implied volatility is higher than the historical volatility, the option is theoretically overpriced. Option sellers look for these kinds of opportunities to sell high and buy low. In contrast, option buyers look for underpriced options by searching for market situations in which the implied volatility of an option is lower than the historical volatility (buy low and sell high). You may choose to spend a lot of time screening markets to determine their volatility. In general, there are two very different kinds of markets. The first one has plenty of movement, and high volatility. The second market has very low volatility. In general, sell options with high volatility and buy options with low volatility.

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