Option Volatility: Why Is It Important?

Volatility is simply a measure of the rate and magnitude of the change of prices (both up and down) of the underlying. When volatility is high, the premium on an option will also be relatively high, and vice versa as well. If you are able to assess a measure of statistical volatility (SV) for any underlying, you can then input the value into a standard options pricing model in order to calculate the fair market value of the option.

The impact of volatility on options trades

It’s important for option traders to remember that volatility changes have the potential to impact any options trade either positively or negatively. Besides this so-called Vega risk/reward consideration, in this tutorial we’ll also examine the relationship between SV (also known as historical volatility) and implied volatility (IV), including how each is calculated. Today, most trading platforms provide these figures for you, but it’s still useful to have an understanding of the underlying concepts.

Historical vs. implied volatility

A trader can use historical and implied volatility to help assess whether options are expensive (relative to past levels) or inexpensive. Finally, we’ll examine the question of whether options are over- or undervalued. This relates to theoretical prices versus market prices and it also incorporates both historical and implied volatility.

Whether you’re a beginner or an expert options trader, it’s likely you’re somewhat familiar with the Black-Scholes model of option pricing. This tool was developed by Fisher Black and Myron Scholes in 1973. The model uses a number of variables to determine a fair market value for any option, including time to expiration, historical volatility, and strike price. At the same time, though, a large number of option traders rarely take the time to assess the market value of an option before they establish a position. (For background reading, see Understanding Option Pricing.)

Why might this be the case? These same traders would be unlikely to, say, buy a car or a home without even glancing at the fair market price of either. It could be that this behavior arises from a trader’s perception that the option value might explode if the underlying makes the intended move; this perception, however, overlooks the importance of value analysis to the equation.

Keeping volatility in perspective when considering options strategies and prices allows you to determine relative valuation for options. Because of the way that markets function, options often price in events which are expected. Thus, if you’re considering different options strategies, knowing whether or not those options are “expensive” or “inexpensive” can be very useful in making a determination about whether to sell or buy. Of course, the old adage dictating that investors should buy low and sell high applies in options trading as much as it does in any other type of investing or trading.

Greek option strategies

Volatility analysis can also be crucial in selecting appropriate strategies. Every option strategy has an associated Greek value which is known as Vega (or position Vega). As implied volatility levels change, so too is there an impact on strategy performance Positive Vega strategies (including long puts, long strangles/straddles, and backspreads) tend to do best when implied volatility levels rise. Negative Vega strategies (including ratio spreads, short options, and short strangles/straddles), on the other hand, do best when implied volatility falls. Of course, knowing where implied volatility levels are and how they are likely to change is essential to executing these strategies effectively. Before we can get there, though, we first have to look at what Vega is and how to interpret it.

Finally, in this tutorial we’ll examine ways to use options volatility in relation to vertical and horizontal skews, or situations in which the implied volatility levels of each strike are compared in the same expiration month and across different months (vertical and horizontal, respectively). We’ll follow this by looking at the use of implied volatility as a means of predicting the future direction of stocks and indexes. Implied volatility is useful as a way of predicting price from two angles: first, as a contrarian, when implied volatility has moved too far in either direction, and second, as a sign of potentially explosive price moves when implied volatility creeps incredibly high for no obvious reason. Usually, the latter situation occurs when there is some pending unknown (or, potentially, known) event but it’s unclear exactly how it will affect stock price.

Throughout the tutorial, we’ll offer insights and practical tips about how one can use these concepts. In the next chapter, we’ll take a look at historical volatility.