Options trading are chance game and traders need to understand it thoroughly. The first thing to consider in option trading is volatility, which plays the main role in the ostensibly unreadable calculation of options pricing.
Two Kinds of Volatility
- Statistical volatility
This kind hardly affects options pricing. It is a mathematical expression related to stock’s price variation in the past. Statistical volatility is obviously for historic interest. It does not reveal future price volatility.
- Implied volatility (IV)
Implied volatility looks forward and reveals the summative estimation of the future price volatility of a specific underlying. Thus, it gives a vital insight that helps to forecast the extent, but not the direction of price movement in future.
Significance of Implied Volatility
For success trader needs to learn options trading and implied volatility. The rise and fall in volatility value can hurt or help their position.
There are some strategies to be applied in volatility fluctuations. IV is not observable directly, so primary option pricing models like Black-Scholes model and Binomial model are used by traders.
It is a mathematical formula, where parameters like underlying stock price, current price, expiry date and more are taken into consideration to determine the IV value.
Variables Used in Option Pricing Model
- Current price of underlying security
- Strike price of option under analysis
- Days until expiry
- Current interest rate
- Actual option price
All the above variables can be observed and you will need to use them to calculate implied volatility price.
Example
On 7/12/97 the Zazira had 120 Call option. It was trading at price 4.60. The recognized variables are –
- Current price of underlying security – 118.90
- Strike price of option under analysis – 120
- Days until expiry – 31 days
- Current interest rate – 5%
- Actual option price – 4.60
- Volatility value – ?
To solve unknown variable F, you will need to apply the option pricing model’s mathematical formula and generate a theoretical price that equals to actual option price 4.60. For this example the implied volatility value for Zazira is 30.06 on 7/12/97.
To determine if current reading is low or high it is necessary to calculate average implied volatility. For average implied volatility calculation, the ATM call and put of nearest expiration months are taken (as near as minimum two weeks). For example, if Zazira trading at 130 in August with call and put at 31.6 and 30.4, respectively then you can say that Zazira’s average implied volatility is 31 (31.6 + 30.4/2).
Several Predictable Phenomenons to Consider
During the earning cycles, implied volatility spikes as reports of earnings are about to be released. As soon as earning data is released, Implied Volatility collapses dramatically, because the vagueness surrounding this happening gets removed. Consequently, option prices lower significantly and this fall in volatility often crushes the accurately predicted price action. It results in losing or flat trade.
Another reliable distinguishing aspect of implied volatility is price direction. Traders rush to purchase puts, when price drops. Due to this increased demand, the price increases. Thus, understanding implied volatility behaviour is necessary for options trader.