More on Volatility
July 29, 2002
Outside the world of options, volatility is described by the term beta. Beta is a measure of the relative volatility of a particular stock, when compared with the volatility of a large group of stocks (often the Standard & Poor's 500 Index). A beta value of less than 1.0 means the stock is less volatile, and a beta value of greater than 1.0 means the stock is more volatile, than the group of stocks with which it is being compared. This volatility number is of interest because it allows an investor to know how volatile he can expect his stock to be, when compared with other stocks.When you deal with stock options, you require different information. You 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 much you (or anyone else) would want to pay for its options. (We will discuss how options are priced next time.) When measuring the volatility of a particular stock, its past performance is analyzed by statistical methods. The volatility calculated via this method has no relationship with the beta value, except that stocks with higher beta values have greater volatility numbers.
In the options world, volatility is measured as a percentage. 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. Volatility is of interest to options traders because it is a vital factor in determining the price of options in the marketplace. 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 option prices.
Consider an option with 6 months until expiration with a strike price of 50:
As an example, let's look at a stock priced at 50.
These option prices are very different. The point for you to remember is you will be able to obtain a higher option premium when you sell your call option, if your stock is more volatile.
- If the implied volatility is 90, the option is worth $1250
- If the implied volatility is 50, the option is worth $725
- If the implied volatility is 30, the option is worth $450
CAVEAT: Stock selection remains the most significant factor in the success or failure of your investment program. Options are instruments that enhance the performance of your portfolio, but stock selection is the key.
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