The Big IF

The biggest battles of the Cold War were often fought during the Olympics.  No matter what flag you saluted, it was US verses that “Evil Empire.”  I don’t know about you, but I always felt the other country’s athletes used performance enhancing drugs.  Not to mention their judge’s scores reflected definite political bias.  Biased scoring could award a gold medal to a silver or bronze performance.

You’ve seen the kids who score and rank everything and anything. Holding up a card that is either a 6 or a 9, depending on which end is up.  “Solid nines, but a six from the Russian Judge.”  Simultaneously in Russia kids are jokingly scoring, “A six from the American Judge.”  It’s all perspective.

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Option pricing has its own “Russian Judge,” volatility.  If you don’t understand volatility’s role in option pricing, your gold medal trades might not make it to the platform.

Option prices are based on a number of components; time, interest rates, dividends, price (stock & strike) and potential.  Potential, also known as volatility, is the most subjective.  Hence the ability to be the kink in our attempt for the gold.

Time is constant with all options.  Three days from now or three weeks from now is the same, no matter if you are trading Amazon.Com or AOL.

Interest rates may change up or down, but it’s the same rate for every stock.

Dividends will vary stock by stock.  General Electric’s dividend has nothing to do with General Motors.  So dividends are figured on a stock by stock basis.  The dividends will be the same no matter what strike price, no matter if it’s Puts or Calls, no matter if you’re buying or selling.

Options are priced as a snapshot in time.  The math between price and strike prices at a given point in time is easily figured.

The simplicity of option pricing ends here.  (As if you thought it was simple so far.)

Volatility is the MOST IMPORTANT component in option pricing.  Simultaneously, it may be the MOST DIFFICULT to understand.

Mathematically speaking, volatility is the annualized standard deviation of daily returns.  Translated, it measures the stock’s price fluctuation.  The more the stock moves the higher the volatility.

Volatility scores potential movement of the underlying stock.  The “Greek” symbol Vega measures volatility.  Proving the point volatility is complex, Vega isn’t actually a Greek letter.

With me so far?  It gets worse.  Concerning option pricing, there are four types of volatility; Historical, Future, Expected, and Implied.

Historical Volatility

Simply stated, how much the price of a stock has moved in the past.

Without going deep into math, let me explain the concept.  If you have two $ 50 stocks, the price is currently the same, but historical volatility may differ.

If one stock’s 52 week high/low is $ 40/60, while the other’s is $ 45/55, it is easy to see which stock trading range is greater.  The more a stock’s price moves, the higher historical volatility.

If you have two $ 50 stocks with equal 52 week high/lows, their historical volatility may still be different.  If one had a daily trading range of $ 5, its historical volatility would be higher than a stock with a daily trading range of $ 2.  (Daily trading range equals the difference between the high and low during a one day period.)

Easily verified, historical volatility measures the actual prior price movement.

Future Volatility

An almost useless concept.  Future volatility is historical volatility before it happens.  Price movement before it moves.  After it moves, it’s not in the future, it’s not in the present, it’s in the past. Confirmed after it happens.  Future volatility is accurately measured in the future looking backwards, after it became fact.  Of the four, it is the least important Volatility.

Expected Volatility

Expected volatility deals with the future.  Generally based on prior price movements, it assumes the stock will move in a certain pattern.  Not the what it’s moved, not the what it will move, but the what it should move.

Fairly valued options are calculated according to expected volatility.  However, not all options are fairly valued.  Some options are undervalued and many more are overvalued.  As with anything, buy low sell high.

Certainly more important than future volatility, arguably more important than historic volatility, but definitely less important than implied volatility.

Volatility prices options, but as you will see option pricing determines volatility.

Implied Volatility

The Big IF, the “Russian Judge,” the other side of the coin, the pick pocket of option pricing.  Call it what you want.  Implied volatility costs option traders more money than anything else.

Understanding Implied volatility and Vega allows traders to win more often, but more important to potentially lose less often.

Next we will discuss implied volatility and its ramifications in greater detail.

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