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As uncertainty in the marketplace increases, the price for options usually increases as well.  Recently, we have seen that these moves can be quite dramatic.  Reviewing the concept of volatility and its affect on option prices is an important lesson for beginning and novice traders alike.

Basically, an option can be thought of as an insurance policy—when the likelihood of the “insured” event increases, the cost or premium of the policy goes up and the writers of the policies need to be compensated for the higher risk.  For example, earthquake insurance is higher in California than in Illinois.  So when uncertainty in an underlying asset increases (as we have seen recently in the stock market), the demand for options increases as well.  This increase in demand is reflected in higher premiums or volatility.

When we discuss volatility we must be clear about what were talking about.  If a trader derives a theoretical value for an option using a pricing model such as Black-Scholes, a critical input is the assumption of how volatile the underlying asset will be over the life of the option. This volatility assumption may be based on historical data or other factors or analyses. Floor and theoretical traders spend a lot of money to make sure the volatility input used in their price models is as accurate as possible. The validity of the option prices generated is very much determined by this theoretical volatility assumption

Whereas theoretical volatility is the input used in calculating option prices, implied volatility is the actual measured volatility trading in the market. This is the price level at which options may be bought or sold.  Implied volatilities can be acquired in several ways.  One way would be to go to a pricing model and plug in current option prices and solve for volatility, as most professional traders do.  Another way would be to simply go look it up in a published source, such as the Optionetics Platinum site.

Once you understand how volatilities are behaving and what your assumptions might be, you can begin to formulate trading strategies to capitalize on the market environment.  However, you must be aware of the characteristics of how volatility affects various options.  Changes in volatility affect at-the-money option prices the most because ATM options have the greatest amount of extrinsic value or time premium—the portion of the option price most affected by volatility.  Another way to think of it is that at-the-money options represent the most uncertainty as to whether the option will finish in or out of the money.  Additional volatility in the marketplace just adds to that.

Generally changes in volatility are more pronounced in the front months than in the far out month options.  This is probably due to greater liquidity and open interest in the front months.  However, since the back month options have more extrinsic value than front month options, a smaller volatility change in the back month might produce a greater change in option price compared to the front month.  For example, assume the following (August is front month):

Aug 50 calls (at the money)= $3.00      Vol=.40
Nov 50 calls (at the money)= $5.00      Vol=.30

Following an event that causes volatility to increase we might see:

Aug 50 calls=$4.00        Vol=.50
Nov 50 calls=$6.50        Vol=.38

We can see that even though the volatility increased more in August, the November options actually had a greater price increase.  This is due to the greater amount of time premium or extrinsic value in the November options.  Care must be taken when formulating trading strategies to be aware of these relationships.  For example, it is conceivable that a spread could capture the volatility move correctly, but still lose money on the price changes for the options.

Changes in volatility may also affect the skew: the price relationship between options in any given month.  This means that if volatility goes up in the market, different strikes in any given month may react differently.  For example, out-of-the-money puts may get bid to a much higher relative volatility than at-the-money puts.  This is because money managers and investors prefer to buy the less costly option as disaster protection. A $2 put is still cheaper than a $5 put even though the volatility might be significantly higher.  

So how does a trader best utilize volatility effects in his/her trading?  First, it is important to know how a stock trades.  Events such as earnings and news events may affect even similar stocks in different ways.  This knowledge can then be used to determine how the options might behave during certain times.  Looking at volatility graphs is a good way to get a feel for where the volatility normally trades and the high and low ends of the range.

Bottom line, a sound strategy and calculated methodology is critical to your success.  Why is the trade being implemented?  Are volatilities low and the look like they could rally?  Remember that implied volatility is the market’s perception of the future variance of the underlying asset.  A low volatility could mean a very flat market for the foreseeable future.  If a pricing model is being used to generate theoretical values, do the market volatilities look too high or low?  If so, be sure all the inputs are correct.  

The market represents the collective intelligence of the option player’s universe. Be careful betting against the smart money.  Watch the order flow if possible to see who’s buying and selling against the market makers.  Check open interest to get some indication of the potential action, especially if the market moves significantly.  By keeping these things in mind and managing risk closely, the odds of trading success will increase dramatically.


Stephen L. Papale
Staff Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
spapale@optionetics.com

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