1. Option Volatility: Introduction
  2. Option Volatility: Why Is It Important?
  3. Option Volatility: Historical Volatility
  4. Options Volatility: Projected or Implied Volatility
  5. Options Volatility: Valuation
  6. Option Volatility: Strategies and Volatility
  7. Option Volatility: Vertical Skews and Horizontal Skews
  8. Option Volatility: Predicting Big Price Moves
  9. Option Volatility: Contrarian Indicator
  10. Options Volatility: Conclusion

By John Summa, CTA, PhD, Founder of OptionsNerd.com

Most traders generally think of the strike price in relation to the underlying price and how much time remains on the option as the key fundamentals of pricing. This approach, however, often leads to some negative surprises.  Unfortunately for many option buyers, the expected move of the underlying may already be priced into the option's value. Indeed, many traders sorely discover that when the underlying makes the anticipated move, the option's price might decline rather than increase. This mystery of options pricing can often be explained by a look at expected or  implied volatility (IV). In this part of the tutorial, we'll learn how IV impacts option prices and how IV differs from historical volatility (covered in the previous chapter).

Options volatility is one of the least understood variables behind the movement of daily price changes of an option, but the role volatility plays is quite easy to understand. When an option is quoted throughout the market day, the prices in the form of bids and asks don't tell you much about its valuation in terms of fundamentals. A model's fair market value is often out of line with the actual market value for that same option. This is known as option mispricing. Like any asset with a market price, such prices may actually deviate from the fundamentals due to expected or projected events not captured by asset pricing models - and that difference largely can be attributed to IV.

What good is a model of option pricing when an option's price often deviates from the model's price (that is, its theoretical value)? The answer can be found in the amount of IV the market is pricing into the option. Option models calculate IV using SV and current market prices. For instance, if the price of an option should be three points in premium price and the option price today is at four, the additional premium is attributed to IV pricing. IV is determined after plugging in current market prices of options, usually an average of the two nearest just out-of-the-money option strike prices.

A Common IV Pitfall
Let's say that an option trader is interested in buying high beta tech stock call options because he or she is bullish on the stock. Because high beta stocks have the potential to make big moves, the trader thinks that the potential for profit is higher when buying call options. However, options on these stocks, especially around pending news, can experience a change in the price even without movement of the underlying. Prices may move higher (again even without a stock price move) simply because there is a big move expected. And this will typically occur on the puts and calls. In this case, IV is going to be high. (To learn more, read Beta: Gauging Price Fluctuations.)

When the news comes out and the stock moves higher as expected by the trader, the results are often disappointing in terms of changes in the option price and what Delta implies the price should actually be. The reason is that the reverse movement in IV occurs, IV falls after the news (like letting the air out of a balloon) and the IV (and with it lots of extrinsic value) deflates quickly. With this drop in IV, the call buyer is often left miffed as to why he or she did not make much, if anything, on his or her speculative purchase of calls. (For related reading, see Getting To Know The "Greeks" and Price Plunging? Buy A Put!)

Now, when it comes to put buying, there can be both good and bad surprises. The same process outlined above will operate when buying puts, especially if puts are purchased during bearish cycles in the stock (IV typically for most large cap stocks will be pumped up at this point). If the puts are purchased when they are "cheap" in terms of IV levels (this occurs when you buy the puts when the trend has been upward and price action relatively uniform (and assuming no big pending news outcome), then it is possible for IV to rise if the stock enters a bearish cycle. This can lead to a positive surprise in the change of the option price, provided you purchased the option when the IV was low near the market top. Here, the price would increase more than that which is suggested by Delta (leaving any significant changes due to Theta or the rate of time value decay aside for now).

Returning to the calls for a moment, when the calls are purchased when they are "cheap" from an IV perspective, the potential wheel spinning from IV dropping is reduced, but not eliminated. The bottom line of all this is that without an IV analysis and understanding of how IV and stock prices and options prices relate, a trader is asking for trouble. Therefore, if you want to avoid unnecessary losses, it pays to develop a basic understanding of and familiarity with IV pricing.

How does IV get calculated?
IV is best understood by reference to an option pricing model, such as the Black-Scholes model. As you can see in Figure 5, there are five main ingredients or inputs (right-facing arrows). These are:

 

 

  1. Stock price
  2. Strike price
  3. Historical volatility
  4. Days to expiration
  5. Risk-free rate of interest.

The output is the fair value or theoretical price of an option. However, if you have looked at theoretical prices at all, you know that the fair value price is not always the price the market is setting for the same option.

 

 

 

 

 

Copyright © 2007 Investopedia.com
Figure 5: Black-Scholes options pricing model inputs

Figure 6 helps to explain the fact that option prices in the marketplace tend to deviate from theoretical prices. This fact is captured in the reverse flow model in Figure 6, which shows that the price output is now an input and the volatility input is now an output. The model is solved for volatility when market price is used as an input, and this essentially is how IV gets calculated. Therefore, if market price is greater than it was the day before (all other things remaining the same), the explanation for that difference is attributed to implied volatility.

 

 

 

 

 

Copyright © 2007 Investopedia.com
Figure 6: Black-Scholes options pricing model reversed

The exact derivation of IV we can leave to mathematicians. Practically speaking, if market price is above theoretical prices, this is simply the premium placed on an option's market price by market participants. They are expecting greater volatility than SV currently is signaling, and therefore the imputed volatility, or IV, is telling us what the best guess of the marketplace is for the future volatility of the underlying stock.

Again, this generally is unconnected to direction. Rising IV will generally lift all boats, but IV skews may become more pronounced if they are regular features of a particular market. Skews, also known as IV "smiles" or "smirks" are cause by the warping of prices by the marketplace away from theoretical prices. Therefore, IV levels can vary for each strike along a strike price chain, or across different expiration dates.

Let's take a look at these concepts in action, using cotton call options to to see how they can be put to use. Fortunately, today's options software can do most all the work for us, so you don't need to be a math wizard or an Excel spreadsheet guru writing algorithms to calculate IV and SV. Using the scanning tool in OptionsVue 5 Options Analysis Software, we can set search criteria for options that are showing both high historical volatility (recent price changes that have been relatively fast and big) and high implied volatility (market price of options that has been greater than theoretical price).

Let's scan commodity options, which tend to have very good volatility (this, however, can also be done with stock options).  This example shows the close of trading on March 8, 2002, but the principal applies to all options markets: when volatility is high, options buyers should be wary of straight options buying, and should probably be looking to sell. Low volatility, on the other hand, which generally occurs in quiet markets, will offer better prices for buyers. Figure 1 contains the results of our scan, which is based on the criteria just outlined.

Options Scan for High Current Implied and Statistical Volatility

abc1.gif
Figure 1
Source: OptionVue

Looking at our scan results, we can see that cotton tops the list. IV is 34.7% at the 97th percentile of IV (which is very high), with the past six years as a reference range. In addition, SV is 31.3%, which is at the 90th percentile of its six-year high-low range. These are overvalued options (IV > SV) and are high priced due to the extreme levels of both SV and IV (i.e. SV and IV are at or above their 90th percentile rankings). Clearly, these are not options you would want to be buying - at least not without taking into account their expensive nature.

As you can see from Figure 2, below, both IV and SV tend to revert to their normally lower levels, and can do so quite quickly. You can, therefore, have a sudden collapse of IV (and SV) and a quick fall in premiums, even without a move of cotton prices. In such a scenario, the option buyers often get fleeced.

Cotton Futures - Implied and Statistical Volatility

abc2.gif
Figure 2: SV and IV revert to normally lower levels
Source: OptionVue

There are, however, excellent option writing strategies that can take advantage of these high volatility levels. We will cover these strategies in future articles. In the meantime, it is a good idea to get in the habit of checking the levels of volatility (both SV and IV) before establishing any option position. It is worth investing in some good software to make the job timesaving and accurate.

In Figure 2, above, July cotton IV and SV have somewhat come off their extremes, yet they remain well above the 22% levels, around which IV and SV oscillated in 1999 and 2000. What has caused this jump in volatility? Exhibit 3 below contains a daily bar chart for cotton futures, which tells us something about the changing volatility levels shown above.

abc3.gif
Figure 3
Source: OptionVue

The sharp bearish declines of 2001 and sudden v-shaped bottom in late October caused a spike in volatility levels, which can be seen in the breakout higher in the volatility levels of Figure 2. Remember that the rate of change and the size of changes in price will directly affect SV, and this can increase the expected volatility (IV), especially because the demand for options relative to supply increases sharply when there is an expectation of a large move.

To finish our discussion, let's take a closer look at IV by examining what is known as a volatility skew. Figure 4, below, contains a classic July cotton call options skew. The IV for calls increases as the option strikes get farther away from the money (as seen in the northeasterly, upward sloping shape of the skew, which forms a smile, or smirk shape).

This tells us that the farther away from the money the call option strike is, the greater the IV is in that particular option strike. The levels of volatility are plotted along the vertical axis.

As you can see, the deep out-of-the-money calls are extremely inflated (IV > 42%).

July Cotton Calls - Implied Volatility Skew

abc4.gif
Figure 4
Source: OptionVue

The data for each of the call strikes displayed in Figure 4 is included in Figure 5, below. When we move farther away from the at-the-money call strikes for the July calls, IV increases from 31.8% (just out of the money) at the 38 strike to 42.3% for the July 60 strike (deep out of the money). In other words, the July call strikes that are farther away from the money have more IV than those nearer to the money. By selling the higher implied volatility options and buying lower implied volatility options, a trader can profit if the IV skew eventually flattens out. This can happen even with no directional moves of the underlying futures.

July Cotton Calls - IV Skew

Figure 5

Conclusion
Volatility is a measure of how rapid price changes have been (SV) and what the market expects the price to do (IV). By incorporating into trading an awareness of IV and SV, which are important dimensions of pricing, you can gain a decisive edge as an options trader.

IV measures the market's expected best guess of future volatility of the underlying. It is calculated using the market price of an option, along with other inputs used in price models, and then solving for volatility, in effect by working backwards to solve the price equation (it is actually an iterative process). While this may oversimplify the math somewhat, what is important to remember is that IV captures the degree of excess or deficit value on an option in terms of its theoretical price. Many broker trading platforms provide an IV value for each strike (and usually an average IV for all the stock's options), so you don't need to do the calculation. What should be done, instead, is an analysis of how high or low IV is in relation to previous levels so you can avoid one of the common mistakes made by traders: buying high IV and selling low IV.

 

 

 

 

 

 


Options Volatility: Valuation
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