Volaillity

Volatility

It's importance when determining the price of options in the marketplace.

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.

Outside the options world, volatility is described by the term beta.   Beta is a measure of the relative volatility of a specific stock, when compared with the volatility of a large group of stocks (often the Standard & Poor's 500 Index). A beta of 1.0 means the stock has the same volatility as "the market" as a whole. Stocks with beta values less than 1.0 are less volatile than the market, while stocks with beta values greater than 1.0 are more volatile. Beta is useful because it allows an investor to estimate the price movement of his/her stock, compared with the overall market.

When we deal with stock options, we must know the volatility of the stock as a stand alone item. Comparing its volatility to that of other stocks is of no use in determining how its options should be priced because options have specific strike prices and it's important to calculate the chances that the stock will move beyond the strike price before the options expire. When measuring volatility of a specific stock, a statistical analysis is made using the real daily price changes for each stock. This volatility measurement is unrelated to beta, except that stocks with higher beta values have higher volatilities.

In the options world, volatility is measured as a percentage, and price changes are measured from one day’s closing price to the next. To put it into familiar terms, when a stock is described as having a volatility of 30 (Volatility = 0.30), it means the stock moves (either up or down) by 30% or less, approximately 2 years out of every 3.  A move twice that size (60% in this example) occurs about once every 20 years.

For a more detailed explanation of Volatility and how you can use it to become a better option trader, see

The Rookie's Guide to Options

There is more than one type of volatility. Historical Volatility is calculated by measuring the stock's past price movements.  When dealing with options, you want to know the volatility the stock is going to have from the time the option is purchased (or sold) until expiration.  That volatility can never be known, because the time frame is the future. Thus, the best we can do is estimate that future volatility. That estimate is based upon more than the volatility history of the stock.  It also takes into consideration any events that are known to be occurring during the lifetime of the option - events that have a chance to make an impact on the stock price.  An example of such an event is the quarterly announcement of the company's earnings.  Also included in the volatility estimate is the general condition of the market.  Sometimes markets are calm, and all volatility estimates are reduced.  At other times, world events have an impact on stock prices and volatility estimates are raised.  The term used to describe the estimated future volatility is forecast volatility.   Sometimes it is simply referred to as estimated volatility.

When we look at option prices, we use a different term: implied volatility. Unlike other types of volatility, this is a property of the option (rather than of the stock).  Implied volatility is the estimate, made by professional traders in the marketplace, of the future volatility of the stock.  Another way to  describe implied volatility is: it's the volatility, that when substituted into the equation used to calculate theoretical values, makes the theoretical value equal to the actual price of the option in the marketplace.

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Volatility is of interest to options traders because it's a vital factor in determining the market price of options. Option buyers make money when stocks undergo significant price changes (if the change is in the correct direction).  Because volatile stocks are much more likely to undergo large price changes, option buyers pay a much higher premium for options of volatile stocks.  As a result, the options of similarly priced stocks often have vastly different premiums.

As an example, let's look at a stock priced at 50.

Consider a 6-month call option with a strike price of 50:
• If the implied volatility is 90, the option price is    \$1250
• If the implied volatility is 50, the option price is      \$725
• If the implied volatility is 30, the option price is      \$450
These premiums are very different.  The point for you to remember is you can receive a higher cash premium when you write call options, if the underlying stock is volatile.