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Option Volatility
The Smart Profits Report: Issue # 186
Wednesday, February 23, 2005
Option Volatility: A Free Tool for Finding the Best Option Bargains
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
When it comes to option trading, you can either buy them when they’re cheap or buy them when they’re expensive. Do you know how to tell when they’re expensive and when they’re not?
I’ll give you a hint: It all depends on the “option volatility.”
There are six factors that determine the price for an option contract.
- Price of the underlying stock
- Strike price of the option
- Time to expiration
- Volatility
- Interest rates
- Dividends
All of the factors except for “volatility” are either set by the options exchanges or are readily available information for everyone to use. Volatility is the only factor that is not universally accepted by all market participants.
So to get a leg up on the markets, you need to understand the sole remaining factor: volatility. It gives you a way of knowing which options are bargains, and which are not.
Here’s what I mean…
How to Quantify Volatility In Options
Volatility, as it applies to options trading, is a number that quantifies how volatile the underlying stock has been in the past, as well as how volatile it is expected to be in the future.
There are two types of volatility that relate to options trading:
- “Historical volatility” measures how erratic, or volatile, the stock has been in the past…
- “Implied volatility” (or beta) measures the options market’s view of how erratic, or volatile, the stock might be in the future.
Since there are different time frames in which to measure volatility, as well as different ways to calculate volatility, you can guess that the volatility factor that goes into pricing an option can be confusing.
Some traders like to use a 10-day, 30-day, or 50-day historical volatility in pricing options, while others like to use the current at-the-money implied volatility of the front-month options.
Some like to calculate the volatility using the closing price of the stock, while others like to incorporate the high, low and close of each session.
Regardless of how the volatility is calculated or which measure is used, we are not concerned with that in this discussion. We are concerned with how to tell whether options are expensive or cheap before we buy them.
Volatility can tell us just that. When it comes to determining whether options are cheap or expensive, it’s the volatility that gives us the clues.
Critical to Success: Buying When Volatility Is Low
Just like a regular stock chart, volatility fluctuates in the same manner. Volatility will oscillate between high and low. Your job as a Smart Profits trader is to know whether volatility is at a high or low level before purchasing your option contracts.
Of course, buying when volatility is low is a must… and one of the best ways to put the odds of success on your side. How do you tell if volatility is high or low?
Just look at a volatility chart. These are published at various websites, and if you use a data provider to receive charts and quotes, some provide historical and implied volatility as available indicators. One of the best websites I know of to see volatility charts and volatility statistics is http://www.ivolatility.com.
Why is it important to buy options when volatility is low? Because volatility has a direct effect on the price of an option.
When a stock is fluctuating wildly, that means the stock is volatile, which in turn increases the volatility component. When volatility increases, so do option prices. When stocks are stagnant, volatility decreases, which in turn brings down the option premiums.
An Volatile Example Using IBM…
Just as an example, if you look at a one-year volatility chart for IBM at ivolatility.com, you will see that the implied volatility hit a peak of 25% at the end of March 2004, and is hitting a low of around 13% at present. If you priced out the IBM March ‘05 $95 call with a volatility level of 13% using an option calculator, you will yield a premium of $1.40.
Now, if you substitute a volatility level of 25%, the same $95 call will cost you $2.97, more than double the price when compared to the lower volatility number. (Remember, when volatility increases, so do option prices…)
What Option Volatility Means for You as a Trader…
What does this mean for the option trader? Well, it means that if you plan on buying an option, you better check the volatility level to see if you are buying a cheap or expensive option. If you buy an expensive option and the stock doesn’t move in your favor right away, not only will you lose because the direction was wrong; you will most likely lose even faster if volatility starts to come down.
If you buy an option when it is cheap and the direction goes against you, you won’t lose as fast because the volatility is already low and it won’t suck much more value out of it because of that.
Bottom line here is to always make sure you’re aware of the volatility levels before initiating an option position. As you take in all the other factors before making a trading decision, such as technical and fundamental issues, why not add another tool to your arsenal to increase your odds of success? Check the volatility!
Good trading,
Lee Lowell
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Today’s Smart Profits Cribsheet
- For more on volatility, check out Karim Rahemtulla’s take on it in Smart Profits #107: Using Volatility: How to Pay $27 for a $50 Stock.
- Swing over to our Smart Profits Glossary for definitions of words like “implied volatility” or “covered calls.”
Related Articles:
- Understanding Options Risk - How to Beat the “Volatility Premium” on Options
- Implied Volatility - The Impact of Beta on Your Option Positions
- Using a Probability Calculator - Know Your Trade’s Exact Chance of Success Up Front
