A good way to look at the significance that volatility plays in the pricing of options is the following extreme example.
- On the 21st September 2001 (following the New York tragedy) trader John wanted to buy the FTSE 100 index feeling that it was far too low
- On the exact low of the move with the index at 4,220 he bought one Dec 4,800 call for 350 points or £3,500 per contract
- John's forecast that FTSE was heavily undervalued couldn't have been better and by the option expiry date of 21st December 2001 the FTSE 100 index stood at 5,100, a massive gain of nearly 21%
- However the Dec 4,800 call was only worth 300 points or £3,000, and therefore a loss of £500 was recorded on the trade
How can this be right, John did everything by the book, he bought a call which 'always' make money when the underlying rises…..?
It's All To Do With Volatility
But textbook theory, as is proved in this case, doesn't always play out perfectly.
The reason he lost money was that he bought an option when volatility was at a historically high level. This meant that all options whether Puts or Calls were priced at extremely high premiums.
Trader John therefore ended up fighting a battle on two fronts –
- The direction of the market, which he got spectacularly right, and
- A battle against falling volatility which was his downfall
The profits on direction were more than eaten up by the losses caused by volatility shrinking, so reducing the premium of his option.
It was as if everyday the market went higher, the option’s price gained by 10 points (due to the stockmarket’s gain) but volatility shrunk taking 10.5 points away.
Think about the above, and don’t get involved in Options unless you fully understand what’s going on. Trade options without having a clear idea of what volatility is and losses will probably be your only result overtime.
