is the property of a stock that describes its tendency to undergo price
changes. More volatile stocks undergo larger or more frequent price
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
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.
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
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
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
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.
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.
If you adopt a covered call writing strategy,
be aware that your potential profit is greater if you own more volatile
stocks. WARNING: This is NOT a suggestion that you buy volatile
stocks. It is just a statement to make you aware there is one
additional factor you can take into consideration when making the decision
on which stocks you want to own, and that factor is the volatility
of the stock (or the price of the options you intend to sell). This
article deals with stock volatility, so it is worth mentioning that volatility
is not a factor that investors usually take into consideration when
compiling a list of stocks they are considering for future purchase.
We are suggesting you make it a minor factor. Less volatile stocks
have the benefit of greater safety for the portfolio. More
volatile stocks have the benefit of higher prices for the options
you sell. It's up to you, as the owner of the stocks in your portfolio,
to make purchases that fit your comfort level. We don't give advice on
buying stocks, except for this: Buy stocks you want to own.
When trading options,
you are going to be interested in the theoretical value of an option.
Volatility is one of the factors used in the Black - Scholes option pricing
calculator that make does the work for you is provided
A more detailed discussion of the theoretical value of an option is