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Options Tutorials (Page 7 of 11)

Summary:
Volatility is so important to understand when dealing in Options. Look at the examples on this page to get a better feel of how Volatility works in relation to how the underlying stockmarket moves.

Volatility Examples

Note, the below example is several years old. This doesn’t matter as the 2002 – 2004 stockmarket makes a good historical example of the study of volatility. Another example, but this time of rising volatility would have been the stockmarket of 2006 – 2008.

Look at the table of various London stocks and how their implied volatility levels move over 2 years. Then look at the FTSE 100 chart and see the price movement of stocks during this same period.

At the start of this time period (Oct 2002) the overall stockmarket was very volatile and was also extremely weak. But this also marked the bottom of the bear market and so not only did prices start to move higher but the daily and weekly swings generally got more stable. Hence option volatility steadily declined, meaning that option premiums got cheaper.

Share
Oct
2002
Feb
2003
Jul
2003
Oct
2003
Jan
2004
Apr
2004
Nov
2004
FTSE 100
46%
32%
24%
20%
15%
10%
10%
Alliance & Leic
46%
33%
27%
21%
17%
17%
17%
Allied Domeq
42%
33%
26%
24%
21%
19%
19%
P & O
50%
35%
32%
29%
27%
23%
20%
Vodafone
74%
46%
33%
25%
15%
23%
20%




Using the FTSE 100 as an example from the above table and chart.

See how in October 2002, when the market had been falling very sharply (it had lost over 25% in less than 3 months) Volatility was 46%. This meant that Option prices were forecasting that the FTSE 100 was expected to move in a 46% range (either up or down) over the coming year.

But as the market bottomed in early 2003 and started to rise the risk of further falls started to erode. Hence Volatility 4 months later dropped to 32%.

As the market continued to move higher it had dropped to 24% and continued to fall sharply towards the end of 2004 when it was at just 10%.

10% means as you should now know that Option prices were forecasting the FTSE 100 to trade within a 10% band over the coming year. Clearly over the 2 or so years Option volatility went from one extreme to the other.

Traders who bought Options when volatility was above 40% would have had a tough time making money. Conversely I think that traders who sold Options short when Volatility was at 10% were probably selling them far too cheap.

Example of How Falling Prices Produces a Rise in Option Volatility

The lower red line is implied volatility. See how it is basically flat during November 2002 till May 2003 as the overall stockmarket trades sideways.

Then, as soon as the decline starts implied volatility starts to rise and then quickly gains momentum.

FTSE 100

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