The Options Market Explained

Volatility has a great influence when valuing options. It measures the rate at which the price of the underlying asset, up or down, varies. Suppose 2 actions:

1. Stock A: Over the last 2 years, prices move 5% a month on average. That is, between the maximum and the minimum of the month, the average distance is 5% ($10.50 max and $10 min)

2. Stock B: Over the last 2 years, prices move 20% a month on average. That is, between the maximum and the minimum of the month the average distance is 20% ($12.00 max and $10 min).

Stock B is more volatile (the discrepancy is larger), and therefore your options will have a higher price.

We will see it intuitively with an example:

Imagine both shares are trading at $10, and an investor is thinking of buying the $11 call from both companies, due within 1 month. It is very difficult for company A to rise above $11/share , since that would mean a move of 10% and given the history of the stock, it will most likely not exceed $10.50/share. Therefore, the $11 option of the company will have a very low price, since it is most likely that within 1 month it wont be worth anything. Although the price will be low, it wont be $0, since there is always a small possibility that it has a movement above average.

On the other hand, company B tends movements in price twice as large than company A (20%), so company B is much more likely to exceed $11/share within 1 month, and therefore the $11 call on company B will have a much higher value.

It is important to keep in mind that volatility does not say anything about whether a company is bullish or bearish, it only shows the speed with which it moves. If company B moves 20% on average a month and is listed at $10  within 1 month, its price could be $12 or $8. Volatility only the degree to which a stock may move, not whether it will move up or down.

There are 3 types of volatility:

1.Historical volatility: It is the one we have seen so far, which has had the underlying asset in the past. It is known and can be measured, although the same underlying asset may have a volatility in the last 3 months different from the one in the last year, in the last 5 years etc… The same underlying asset usually has similar volatilities for different time periods, although this is not always the case.

2.Future volatility: The movement of the underlying asset in the future, and like any future fact, it’s impossible to know in advance. Obviously, it’s the most important of all, since it would be equivalent to knowing what the underlying asset will do in the future.

3.Implicit volatility: It is currently traded on the market. It represents the average opinion of all the participants in the options market on what future volatility will be. It is incorporated in the trading of the options in the market, although it is not exactly the same for all the options of the same underlying asset. Implied volatility varies constantly, just like the stock price.

Increases in volatility increase the price of options (call and put), and conversely, volatility declines decrease the price of options. Following the principle of “buy cheap and sell expensive” option buyers are interested in buying when the volatility is low. And option sellers are interested in selling when volatility is high.

Given the enormous amount of leverage one can exert when trading options, be advised that you should only engage in option trading when you have done your homework thoroughly. In general, I’d steer clear of options trading if you’re a beginner investor.

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