Introduction to the Concept of Volatility
June 26, 2002To learn about our book, click here .
What do you hope will happen if you purchase a call option? Let's recall that the owner of a call option has the right (but not the obligation) to purchase 100 shares of a specified stock at a specified price (strike price) at any time before the option expires. Thus, if you have the right to buy the stock for a given price, you hope the stock rises in price. The more it goes up, the more you make, as the owner of a call option.
For example, if you have the right to buy 100 shares of stock at $40 per share, and if the stock is trading at $50 per share, you have an option that is in-the-money and is worth at least $1000.
If you exercise the option and buy the stock for 40, you pay $4000 for the 100 shares. You can simultaneously sell that stock in the marketplace for 50, or $5000 for the 100 shares. This nets you $1000, less commission. Thus, the option is always worth at least $1000 in this scenario. The higher the stock price, the more the option is worth.
The point of the above discussion: in order to make money from the purchase of an option (call or put), the price of the underlying stock must change. The greater the change in the price of the stock, the greater the potential profit for the option owner. Of course, if the change in stock price is in the wrong direction (if the stock goes down when you bought a call), then you will have a loss and not a profit. However, the more a stock is likely to move while you own the option, the greater the potential profit. The greater the potential profit, the more an option is worth. The more the option is worth, the more it costs you when you buy the option (or the more you receive when you sell it).
Stocks that have the potential to undergo large changes in price are said to be volatile. Stocks that have the tendency to undergo smaller, or less frequent changes in price, are said to be non-volatile. The volatility is a crucial factor in determining the value, and hence the price, of an option.
When you study stock options, an understanding of volatility, and how it affects the prices of options, is crucial. Next time we will deal with the subject of volatility in more detail. If you are interested in reading a description of volatility that is geared to the more advanced options trader, then click here.
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