by Amanda Harvey
Option volatility refers to the amount of fluctuation experienced in the price of an option. Volatility in the market in general, and of the price of the underlying asset certainly correlate to the volatility of the option, however there are other factors, and specific concerns which relate to volatility in trading options.
How Is Volatility Determined?
Volatility, including option volatility, is determined in one of two basic ways, the first of which is described as Historical Volatility. This method calculates the amount of fluctuation that a price has experienced over a certain period of time up to that moment. Using this calculation, an asset is deemed to have a current level of volatility which expresses an average of the historical volatility documented during the preceding period. This gives a fairly accurate indication of how volatile the asset has been, but does not guarantee that the matching level of volatility will continue beyond that time.
The other type of volatility calculation determines Implied Volatility. This volatility measure attempts to forecast the probable future volatility of the price of an asset. Calculating implied volatility takes into account considerations such as upcoming earnings reports and economic factors. It is important to bear in mind that, as a prediction of a likely future outcome, rather than a calculation of actual historical data, implied volatility can only provide theoretical information.
Comparison of Stock and Option Volatility
Volatility in option trading is especially relevant, as the level of implied volatility correlates directly to the price of the option. Generally speaking, an increase in implied volatility results in an increase in option price. For the holder of an option contract, this is obviously an advantageous situation. The reverse, of course, is also true, in that a decrease in implied volatility translates to a drop in the option’s price.
The changes in the implied volatility of a stock are not necessarily mirrored in the corresponding option. The sensitivity of an option to changes in implied volatility can be measured by one of the mathematical formulae known as the Option Greeks. Vega is the measure used to determine the rise or fall in value that an option is expected to experience in relation to a rise or fall of one point in volatility.
There are other factors which influence the degree to which option volatility corresponds to changes in implied volatility. One of these factors is the amount of time remaining on an option contract. Option contracts with a longer time before expiration are more responsive to movement in volatility, whereas options nearing their expiration date are less affected by these changes. This variance is due to the amount of ‘time value’ which is inherent in an option contract.
Another determining aspect of option volatility compared with the implied volatility of the underlying stock is the relationship of the option price to its strike price. An option that is near- or at-the-money is more susceptible to changes in volatility than an option which is deep in- or out-of-the money.
Why Does Higher Volatility Mean Higher Option Prices?
An option contract is purchased with the goal of its price moving a certain amount before expiration to reach its strike price. If there is little volatility in the price of the underlying stock, there is less chance that the price will move sufficiently for the option to expire in-the-money. Conversely, greater volatility offers better possibility of the option reaching its strike price, and as such, the option is a more promising investment which can command a higher price.
Using Option Volatility to Find Trading Opportunities
A trader may look for times when an option is showing a lower than typical level of implied volatility for opportunities to buy an option at a low price. If the implied volatility is expected to rise, this can offer an opportunity to sell the option within the duration of the contract at an increased price. When undertaking a trade in this manner, it is important to ensure that there is sufficient time prior to expiration to allow the anticipated increases to occur.
Understanding option volatility is a very important factor to being able to determine opportunities to buy options, as well as deciding on expiration dates, strike prices, and when to sell.