Market volatility is one of the most important factors affecting the pricing of options.
If volatility is high, options premiums are generally relatively expensive.
If volatility is low, options premiums tend to be comparatively cheap.
Regardless of market direction (up or down), volatility is a measure of the amount and speed of price changes.
Volatility is how much variability there is in the price changes of a stock or index. The more variation there is, the higher the volatility.
More volatile stocks undergo larger and/or more frequent price changes.
Options depend greatly on market volatility. If the marketplace feels a stock will be very volatile, the practical (extrinsic) value of the option rises.
If the marketplace thinks the stock will be less volatile, then the practical value of the options decline.
Future volatility expectations are important to the marketplace.
There are two common types of volatility that are usually applied to option volatility:
1. Historical Volatility (HV)
Historical Volatility measures how volatile the stock has been in the past. You need to determine a period of time (one year, six months, one month, twenty days) to be able to calculate the volatility. Twenty days is usually the standard period of time used in calculations, as there are generally twenty trading days in a month.
More technically, Historical Volatility is an annualized standard deviation of price changes expressed as a percentage.
2. Implied Volatility (IV)
Implied Volatility is the market’s opinion of the volatility of the option’s underlying security and is determined using a number of types of information;
• The price of the stock
• The market price of the option
• The strike price of the option
• The expiration date of the option
• The interest rate
• The dividends
These are all determined using various theoretical option pricing models such as the Black Scholes Model.