Option Volatility Explained

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How Interest Rates and Volatility Affect Option Prices?

Both interest rates and underlying stock’s volatility have an influence on the option prices.

Impact of Interest Rates

When interest rates increase, the call option prices increase while the put option prices decrease.

Let’s look at the logic behind this. Let’s say you are interested in buying a stock which sells at $10 per share. You buy 1,000 shares at $10 each with a total investment of $10,000. Instead of directly buying the stock, you could also have purchases a call option selling for only $1, making a total investment of $1 x 1,000 = $1,000. If you choose to buy the call option instead of the underlying stock directly, you could have used the remaining $9,000 to earn some interest. The higher the interest rates, the higher your interest income would be. This makes the call option more attractive and more expensive.

For put options, the opposite holds true, that is, the higher the interest rates the lower the put option price. This is because if interest rates are high you will have to hold the asset for a longer time to deliver it under the put option. Simply selling the asset and using the proceeds to invest at a higher rate would be a better option. This makes the put option less attractive and hence less costly when interest rates are high.

This said, the impact of interest rates on option prices is minimal.

Impact of Volatility

Unlike interest rates, volatility significantly affects the option prices. The higher the volatility of the underlying asset, the higher is the price for both call options and put options. This happens because higher volatility increases both the up potential and down potential. The upside helps calls and downside helps put options.

Learn About Volatility Skew

Volatility skew is a options trading concept that states that option contracts for the same underlying asset—with different strike prices, but which have the same expiration—will have different implied volatility (IV). Skew looks at the difference between the IV for in-the-money, out-of-the-money, and at-the-money options.

Implied volatility can be explained as the uncertainty related to an option’s underlying stock, and the changes triggered at different options’ trading prices. IV is the prevalent market view of the chance that the underlying asset will reach a given price. In-, at, and out-of-the-money refers to the strike price of an options contract as it relates to the going market price for that asset.

Volatility skew is important to watch if you buy and sell options because the implied volatility rises as the uncertainty around its underlying stock increases.

The Volatility Smile

When options first traded on an exchange, volatility skew was very different. Most of the time, options that were out-of-the-money traded at inflated prices. In other words, the implied volatility for both puts and calls increased as the strike price moved away from the current stock price—leading to a “volatility smile” that can be witnessed when charting the price data.

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That is a situation in which out-of-the-money (OTM) options (puts and calls) tended to trade at prices that seemed to be “rich” (too expensive). When the implied volatility was plotted against the strike price, the curve was U-shaped and resembled a smile. However, after the stock market crash in October 1987, something unusual happened to option prices.

There is no need to conduct extensive research to understand the reason for this phenomenon. OTM options were usually inexpensive—in terms of dollars per contract. They were more attractive for speculators to buy than as something for risk-takers to sell—the reward for selling was small because the options often expired worthlessly.

Because there were fewer sellers than buyers for both OTM puts and calls, they traded at higher than “normal” prices—as is true in all aspects of trading (i.e., supply and demand).

The Effects of “Black Monday”

Ever since Black Monday (Oct 19, 1987), OTM put options have been much more attractive to buyers because of the possibility of a gigantic payoff. In addition, these puts became attractive as portfolio insurance against the next market debacle. The increased demand for puts appears to be permanent and still results in higher prices (i.e., higher implied volatility). As a result, the “volatility smile” has been replaced with the “volatility skew”. This remains true, even as the market climbs to all-time highs.

In more modern times, after OTM calls became far less attractive to own, but OTM put options found universal respect as portfolio insurance, the old volatility smile is seldom seen in the world of stock and index options. In its place is a graph that illustrates increasing demand (as measured by an increase in implied volatility (IV) for OTM puts along with a decreased demand for OTM calls.

That plot of strike vs. IV illustrates a volatility skew. The term “volatility skew” refers to the fact that implied volatility is noticeably higher for OTM options with strike prices below the underlying asset’s price. And IV is noticeably lower for OTM options that are struck above the underlying asset price.

IV is the same for a paired put and call. When the strike price and expiration are identical, then the call and put options share a common IV. This may not be obvious when looking at options prices.

The inverse relationship between the stock price and IV is a result of historical market evidence demonstrating that markets fall much more quickly than they rise. There currently exists a number of investors (and money managers) who never again want to encounter a bear market while unprotected, i.e., without owning some put options. That results in continued demand for puts.

The following relationship exists: IV rises when markets decline; IV falls when markets rally. This is because the idea of a falling market tends to (often, but not always) encourage (frighten?) people to buy puts—or at least stop selling them. Whether it is increased demand (more buyers) or increased scarcity (fewer sellers), the result is the same: higher prices for put options.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

What Is Implied Volatility And Why Should Investors Care About It?

Implied volatility attempts to predict the extent of stocks’ future moves and helps determine the prices of options

Implied volatility can be a confusing concept for investors who are just starting to trade options. While the idea of volatility is easy to understand, trying to estimate it is more difficult. However, making the effort to learn about implied volatility is worthwhile because understanding the concept can help investors determine the likely behavior of stocks over time and decide whether the prices of stock options are attractive.

What Is Implied Volatility?

Investors will often call implied volatility “IV.” The Greek letter σ, or sigma, is also used as a symbol for implied volatility. As the name suggests, IV is an estimate of the future likely movement of a given stock. Investors should not confuse IV with historical volatility, which measures the magnitude of stocks’ movements in the past. IV pertains exclusively to what analysts believe will happen in the future. Although volatile stocks can rise meaningfully, volatility is usually more closely associated with declines in stocks’ prices.

What Is Implied Volatility Used For?

Although one can use implied volatility to predict a stock’s behavior, investors typically use it to evaluate the likely future magnitude of the movement of stock options. Options give investors the right to buy or sell a stock at a specified price for a given amount of time. Investors usually purchase stock options for insurance or speculative purposes.

What Is Implied Volatility’s Relationship With Standard Deviations?

Analysts estimate implied volatility using percentages and standard deviations over a given period of time. For example, let us suppose X stock trades at $100 per share. If its IV stands at 20%, a movement of 20%, or $20 per share, over a 12-month period would be equal to one standard deviation.

There is about a 68% chance that any stock will be within the range of one standard deviation at the end of the time period for which IV is calculated. Consequently, there is a 68% chance that the $100 stock with the 20% IV will be between $80 and $120 per share 12 months from now. As IV declines, the range covered by one standard deviation narrows. If the IV of Stock X had been 10%, the range of one standard deviation would have been $90-$110 per share.

What Is Implied Volatility’s Relationship With Stock Option Attributes?

Put simply, higher volatility, sometimes called IV expansion, creates higher uncertainty about the future price action of the stock. As a result, IV expansion causes the prices of options to increase because the writers of options have a greater chance of losing a large amount of money. IV contraction, which occurs when volatility falls, has the opposite effect on option prices.

The amount of time in which an option expires affects IV. Since there is a greater chance for volatility over a longer period of time, options that expire further in the future tend to have higher IVs. Conversely, the IVs of options that expire in a short period of time tend to be lower.

To determine the volatility of an option that expires in thirty days, the implied volatility for the year is multiplied by the square root of 30 divided by 365. Of course, 30 days divided by 365 is the proportion of the year represented by 30 days. For our previous example involving Stock X, one month of volatility would be calculated as follows:

Standard Deviation = $100 x .2 x [Square Root(30/365)]

That yields a one-month standard deviation of 5.73. So there is a 68% chance of the stock trading between $94.27 and $105.73 per share 30 days from now.

What Is Implied Volatility’s Relationship With Stock Prices?

Another factor that affects the implied volatility of a stock is the demand for it. The prices and valuations of hot tech stocks such as Amazon (NASDAQ: AMZN ) and Netflix (NASDAQ: NFLX ) have soared in recent years. These jumps increase the chances of higher price swings in the future. As a result, these stocks have higher volatility levels. The prices of options on such stocks are usually higher. Conversely, blue-chip, slower growth stocks such as Johnson & Johnson (NYSE: JNJ ) tend to move less. J&J’s lower multiple, slow growth and consistent dividend keep its stock price more stable. Consequently, the prices of J&J’s options are lower than those of Amazon and Netflix. .

Final Thoughts on Implied Volatility

Factors such as the amount of time in which an option expires and the demand for the underlying stock also can drive IV higher. Conversely, options with shorter expiration times and less volatile underlying stocks tend to have lower IVs and lower prices.

IV can help investors determine whether an option is overpriced or priced too low Although nobody can accurately predict the future, investors can use IV to anticipate stock price movements more prudently and to increase their chances of paying fair prices for options.

More volatile stocks tend to move in wider ranges. Stocks that move in broader ranges have high IVs, causing the prices of options on those stocks to be higher than those of less volatile stocks, all else being equal.

As of this writing, Will Healy did not own shares of any of the aforementioned securities. You can follow Will on Twitter at @HealyWriting.

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