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Option Volatility

What is it - Why it's critical to understand

Page Summary:
If you want to understand options you have to have a solid grasp of what option volatility is, how it moves, and the dominant role it plays when pricing all options.
For people new to options, volatility is the most overlooked but dominant factor in the pricing of options.

Volatility affects the price of an option today and its price in the future.

Sadly, many retail clients lose unnecessary money when starting out with options because they don't fully understand what they're doing, or don't have a solid grounding in the products they're trading.

Trading without understanding the impact that volatility plays is the principal reason many people get sub-standard results when dealing in options.
Think of volatility in terms of car insurance
  • Car insurance is simply about risk, so a 25 year old wanting to insure a Porsche will incur a dramatically higher premium than a 55 year old
  • Translate this example into options: the high-risk 25 year old is a bank share like Barclays, whereas Tesco is the low risk 55 year old

Or to look at it another way, what is the chance of Barclays share price doubling or halving over the next few months versus Tesco? Barclays to many people seems as if its main business is high stake financial gambling. Tesco on the other hand sell us tins of beans, cans of Coke and cheap socks.

The profits of the two companies and more importantly the future stability of these profits couldn't be more different. This will be reflected in how their share price moves and in turn how their options are priced. In other words options on Barclays will cost far more than options on Tesco.

How Is Volatility Measured?

There are two types of option volatility -

  1. Historical volatility, and
  2. Implied volatility
  • Historical - derived from past data, usually the previous x number of daily closes
  • Implied - considers not only what has happened in the past, but also takes a view on the future

Both measurements of volatility are shown as a percentage. The percentage is then used to determine the expected range of the market over a year.

For example, if the current price of Vodafone is £1.00 and its historical volatility is 20% the market is expecting the share to move within the range of £0.80 - £1.20 over the following year.

It is important to note the 20% volatility level is not forecasting either up or down movement, only the expected range of either positive or negative movement.

Another important point to remember is that both historical and implied volatility levels are always changing. Today's reading may differ markedly from one in the future.

Finally, when trading options your view on the future direction of volatility is sometimes far more important than your forecast for the underlying product.

Historical volatility versus Implied volatility

Historical volatility has a major weakness, it only uses past data and therefore is often a useless measurement when trying to price options. For example -

Imagine there was going to be a General Election tomorrow between two parties, A and B -

  • If party A won the stockmarket would open higher by 20% (it's the pro-business party)
  • If party B won the market would open down 20% (the pro-union party)
  • In the weeks leading up to the result both parties were neck and neck, everyone had a view but it was split right down the middle

Chances are as polling day gets nearer the stockmarket would quieten down awaiting the result. As this happened historical volatility would decline because of the lack of price movement leading up to the Election. But implied volatility would remain high because stocks are going to either explode or implode once the Election's result is known.

So the implied rate of volatility is always more important than its historical cousin.

Where to find Implied Volatility?
  • Your broker (call him up and ask)
  • Euronext Daily Sheets for UK equity options
  • Technical Analysis (charting) software packages such as Metastock by www.Equis.com are able to easily calculate and graph historical volatility
  • Dedicated option software packages including the free Hoadley options program - See this FAQ
A Simple Rule For Volatility

A general rule for volatility is -

  • Volatility rises in a falling market, and
  • Volatility falls in a rising market

Think about it, prices are always more volatile when they're heading lower. Lower prices mean the nervousness factor increases among investors.

For example, during the global banking crisis of 2007 onwards stocks got battered in the Autumn and option volatility obviously went through the roof. But when stocks were steadily heading higher from 2003 - 2007 implied volatility contracted to extremely low levels.

The effect that Volatility has on an Option's price
Assume for this example that both the Barclays and Tesco shares are trading at £2.00.

The prices for their similar call options might look like this -

  • Tesco 3 month £2.50 call priced at £0.10
  • Barclays 3 month £2.50 call priced at £0.40

Both option strikes are 25% higher than where the stock is currently trading but why is the Barclays call option worth 300% more than the Tesco one? Because the underlying volatility of Barclays is significantly higher than Tesco's volatility.

So if the risk of significant price movement (either up or down) is higher so is the option price. Therefore all options on volatile markets or stocks will inherently be more expensive than options on non-volatile stocks.

However, as indicated at the beginning of this article, volatility levels can change both in the short and the long term. Barclays, in common with all banking shares, had medium volatility levels for many years - it is only since 2007/08 that the sector's implied volatility was raised to a far higher level.

Give it a few years though and probably the banking sector will quieten down and today's high volatility levels will be confined to history.

Implied volatility examples

The examples below are several years old but this doesn't matter as the 2002 - 2004 stockmarket makes a good historical example of the study of volatility.

The table below shows various London stocks and how their implied volatility levels moved over a 2 year period. Then look at the FTSE 100 chart and see the price movement of stocks during this same period.

Different Volatility levels

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%

FTSE 100 - Daily Movement

At the start of this time period (Oct 2002) the overall stockmarket was very volatile (falling prices). But when the bear market ended at the beginning of 2003 and prices started to recover, the implied volatility of all the stocks as well as the FTSE 100 began to steadily decline.

So whereas option prices, both calls and puts, were historically expensive in the latter half of 2002 they became progressively cheaper throughout 2003 and beyond as the overall volatility levels contracted.

Interesting points re above table and chart
Using the FTSE 100 implied volatilities as an example.
  • In October 2002 the FTSE 100 implied volatility was 46%
  • The market was forecasting the index would move within a 46% price band from its present value
  • So if the FTSE at that time was 3500 the implied volatility was suggesting the price would range between 1,890 (46% below) and 5,110 (46% above)
  • When the market bottomed and started to rise from February 2003 onwards market participants obviously felt the risk of further sharp falls was decreasing and so implied volatility contracted. In Feb 2003 it stood at 32%
  • As the overall market continued to move higher implied volatility continued to drop
  • 1 year on from October 2002 volatility had halved to stand at 20%
  • And it halved again over the next year to stand at just 10% in November 2004
  • 10% would mean that if the FTSE was trading at 5,500 implied volatility was suggesting a range of 4,950 to 6,050
Further implied volatility examples - FTSE 100
  • Assume the FTSE 100 index is at 4,000
  • The list below shows what the Sep 4025 Puts would be worth with differing levels of implied volatility -
  • Volatility at 20% - Options at 194 points
  • Volatility at 30% - 278 points
  • Volatility at 40% - 361 points
  • Volatility at 50% - 526 points
Guidelines for FTSE implied volatility
But how do you know if the implied volatile level of today is relatively cheap, expensive, or fairly valued in relation to the historical average. The following guidelines are for the FTSE 100 index and therefore give an excellent reference point to the whole Stockmarket.
  • Cheap - Under 15%. 10% very cheap - good value to be had in buying options
  • Fairly Valued - 15%-30%
  • Expensive - Starts to get expensive over 30% (Sep/Oct 2001 peaked at over 70%)

Take care with 'historical averages' because they can change over time. A good example of this is pre- 1995 (the start of the dotcom boom) when fair value implied volatility in the FTSE was probably 10% - 20%.

But 10 years later, as the markets got quicker due to a greater number of market participants and more use of computers and computerised trading, the fair value level is more like 15% - 30%.

So what was considered an expensively valued option in 1994 might have been fairly valued in 2004.

Guidelines for individual share's volatility

Sadly, I cannot offer any because the level is company and sector dependent. As you have seen banking shares are normally always going to have higher implied volatilities than supermarket shares.

The quick and effective way of working out whether the implied volatility of an individual share is likely to be cheap, fairly priced or expensive is to see where FTSE 100 volatility is trading.

Shares are obviously correlated to the overall market so if that's volatile most shares will also be.

I would also look at a 1-year chart of the relevant company to see if that offered any further clues. For example, if the first 6 month's price movement had been relatively quiet but then it tanked and started moving violently you can safely assume that implied volatility is probably high.

Conversely, if the share price had been knocked for the first several months of the year but had stabilised and the price was gently rising, implied volatility would have almost certainly contracted.

So many volatility levels - which one to use
If you look at a range of call or put option prices in the table below you'll notice there are different volatility levels for the different strike prices.
Call Option Volatility
Strike Price
Put Option Volatility
May
May
115%
£1.60
111%
110%
£1.80
110%
108%
£2.00
108%
106%
£2.20
106%
105%
£2.40
105%
  • These are call and put volatility levels on Barclays share price which is trading at £2.12
  • The highest level is 115% and lowest is 105%
  • To get some uniform information the main volatility rate that will be quoted is the at-the-money options of the front month
  • Is this case the level is 108%
  • The nearest strike price is £2.00 and the front month is currently May
Changing FTSE 100 volatility after 11th September 2001
Another excellent example of looking at volatilities significance when pricing options is the following -
  • On the 21st September 2001 (following the New York tragedy) trader John wanted to buy the FTSE 100 index feeling that it had fallen too far
  • On the exact low of the move, when the index was at 4,220, he bought 1 Dec 4,800 call for 350 points or £3,500 per contract (in FTSE 100 options 1 point = £10)
  • John's forecast that FTSE was heavily undervalued couldn't have been better and by the option expiry date of 21 Dec 2001 the FTSE stood at 5,100, an impressive gain of nearly 21%
  • However the Dec 4,800 call when it expired was only worth 300 points or £3,000. Therefore a loss of £500 was recorded on the trade

FTSE 100 Daily chart

John used calls to trade his bullish view because he'd heard that they had unlimited upside but limited risk as he could not lose more than he had paid. And at the time the markets were wild so he didn't want to leave himself open to horrendous losses.

Of course, option volatility was at play and John's mistake was simple - he didn't have a good grasp of what volatility was and how it affected the price of all options. So he paid the ultimate of trading humiliations - he was right in his predictions but also lost money.

He didn't realise a battle was being fought on 2 fronts

You should now understand the reason John lost money was that he bought his call option when volatility was at extremely high levels (70%+). In turn all options were incredibly expensively.

John's trade fought a battle on 2 fronts -

  1. The direction of the market - which he got spectacularly right, and
  2. Falling volatility - which he got spectacularly wrong

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 but volatility shrunk subtracting 11 points.

Important - Volatility will always revert to its mean

One of the most important facts about volatility is that it will always, at some stage in the future, revert to its mean.

It therefore never stays high or low indefinitely and people will actively trade this information, trying to take advantage of both high and low volatility levels.

  • If it's very high, traders will look to sell short option premium but this can be extremely risky and is not advised for most readers, at least when starting out
  • If it's very low, they'll look to buy option premium and this can often be high reward/low risk if you buy deep out of the money calls with plenty of time value

However, where many traders encounter trouble is when they either sell historically high levels of implied volatility only for it to go higher or buy historically low levels but it stays low for 1-3 years as happened in 2005-2007.

The point being that just because option volatility is at one extreme or the other it doesn't mean making returns will be easy.

How to start using volatility in your option trading

Use common sense.

We know the critical role that volatility plays when pricing options and we also know that volatility rises dramatically when prices fall dramatically and vice versa. So as a rule of thumb -

  • Favour buying options and option strategies when implied volatility is historically low, and
  • Favour selling short options, or at least don't buy them, when implied volatility is historically high

But for those new to options I personally wouldn't advise starting aggressively shorting options when volatility is high. The risks are simply too high and even one wrong trade can wipe out an account's cash balance.

Summary on Volatility
Ignore the importance of volatility at your peril when dealing in options.

If you're planning on using options occasionally (and simply), as I do, then you don't need to be an expert. Just make sure you've got a well grounded and solid education - making sure you fully understand the points made on this page as well as looking at the FAQ section.

Then, once you're comfortable with volatility, use it like a map - helping to guide you as to which options or strategies to use and whether the odds favour buying, selling them short or doing nothing.

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  • For my personal trading I like to use Core Spread
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