Volatility

Introduction

Everyone recognizes that stock markets around the world recently experienced periods of extreme volatility. Major stock indexes have undergone significant moves, both higher and lower.  Newspapers and TV talking heads often use the word 'volatile' to describe market activity. 

I'm sure the average citizen grasps the idea of volatility in the sense that the markets have made large moves.  But when trading options, the term 'volatility' is especially significant, and it's a topic that makes for a worthwhile discussion.

Volatility
is the property of a stock that describes its tendency to undergo price
changes.  More volatile stocks undergo larger or more frequent price
changes. 

When you buy or sell options, the market price of those options depends on how volatile the underlying stock going to before the option expires.  That time period is obviously the future, and the future cannot be known – but it can be estimated.  Make a good volatility estimate and you trade the option at a fair and reasonable price.  Make a poor estimate and you may sell an option for far less than it's worth, or pay far more than it's worth. 

Future volatility estimates are educated guesses, and there are always differences of opinion.  Thus, some traders are eager sellers at the same time that others are eager buyers of the same option at the same price.  That's what makes markets.  

Most investors don't try to determine an option's value and always assume it trades at a reasonable price.  But, when there's the possibility of an imminent price change – prior to a news announcement, for example – options can trade at extremely high prices. 

Once the news is released, option prices often collapse.  Why?  Because there is no longer any pending news that may affect the stock price.  Thus, future volatility estimates are lowered, resulting in much lower option prices.



Beware of using 'Beta'

Outside the option world, volatility is described by the term beta, which is  a measure of the relative
volatility of a specific stock, compared with the volatility of a
large group of stocks (often the Standard & Poors 500 Index).  We never consider beta as option traders.

When we deal with stock options, we use
the volatility of the stock (or index) as a stand-alone item.  Why?  Because option pricing depends on the likelihood of the stock making a big move in either direction.  When you buy or sell options on ZZX, you don't care how much ZZX moves compared with other stocks, you only care how much it moves.  Options of stocks that have the ability to make large moves demand a much higher premium than options of non-volatile stocks.

Strike Price Selection

Options have specific strike prices and it's
important to have an idea of the probability that the stock moves near (or beyond) the
strike price before expiration.   It's not that you intend to hold an option until it expires – in fact, over the longer term you'll achieve much better results by selling options you own, and buying back options you sold, prior to expiration.  But if ZZX is not very volatile, then buying OTM calls is probably a poor choice because they will likely expire well before ZZX moves high enough to provide a profit.

For example, if you are bullish on ZZX, currently $50, if you buy calls with a strike price of $60, you may see the stock move higher – but neither quickly enough nor far enough to increase the value of these calls. It's very frustrating to correctly predict a rise (or fall) in the stock price, only to discover you bought the wrong option and incur a loss.  The stock's volatility gives you an idea of how likely it is that the stock will move towards, or through, a given strike price in time to give you a trading profit.  Too many rookies buy out of the money (OTM) options because they find the low price to be attractive, only to discover that the option fails to increase in value, even when the stock moves higher.

to be continued

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3 Responses to Volatility

  1. Rik 11/07/2008 at 6:23 AM #

    You say “it’s important to have an idea of the probability that the stock moves beyond the strike price before expiration”.
    While true, it is statements like this, that taken on their own lead to confusion I see amongst newbie options traders. They often think an option must be held until expiration.
    They need to understand that an option can increase in value and be traded for a profit at any time, even if the stock does not reach the strike price, and does not need to be held to expiration to trade for a profit.

  2. Rik 11/07/2008 at 6:26 AM #

    Excellent comparison of volatility and beta.

  3. Mark 11/07/2008 at 8:01 AM #

    Rik,
    Thank you.
    Text corrected.