Why Implied Volatility Is The True "Wildcard" In Options Pricing

Dec. 20, 2012 9:10 AM ETAAPL, CAT, NFLX2 Comments
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OptionTiger.com is founded by Hari Swaminathan, an entrepreneur, everyday person and a self-taught Options trader for over 5 years. Hari also writes the blog at OptionTiger.com, an insightful commentary of the most important issues in macroeconomics, investing, trading, Option strategies, Index and ETFs, Bond markets and more. Hari has a Bachelor degree in Engineering from India, and double MBAs from Columbia University in NYC and London Business School in the U.K. You can read more about Hari on his Linkedin profile.

Before deciding on an Options strategy, do you look at the current Implied Volatility of the Options ? If not, you're making one of the biggest mistakes in Options trading. And the worst part is - when your trade does not work out, you'll be at a loss to understand what went wrong. For example, you bought a Call option when you were bullish. The stock rose in price but your Call option which was supposed to increase in value, did not do so. You're shocked - how could this happen ??

Implied Volatility is truly the "wildcard" in Options pricing. If you bought that Call Option on a stock whose Implied Volatility was 32% for example, and the stock went up by $10, you're expecting to see an increase in the value of the Call option. However, as it rose $10, if the Implied Volatility of that Option dropped 5% points, its likely you'll see no gain the value of your Call option or even a loss.

Implied Volatility of any Option series is provided by all the good Options trading platforms. These platforms also provide the Implied Volatility of individual Options besides the entire expiry series. If you see that a certain Options series has an Implied Volatility of 30%, how do you know if this is high, low or average ? This is the real question all Options traders should be asking.

There is a site called www.IVolatility.com - this site shows you a historical record of Volatility and compares it to current levels of volatility for any stock. See Figure below for a 6-month comparison of AAPL Options. The Blue Line is a 30-day average of Historical Volatility, and the yellow line represents the current levels of Volatility. In the middle of October, AAPL's volatility spiked to about 42% and has since fallen to 30%. If you were a buyer of Options during this time, it's very possible that you would have seen the stock move in your direction, but because of the drop in Volatility, you may or may not have seen any profits. Similarly, in the beginning of August, AAPL Volatility was at its low of 20%. This would have been an ideal time to be a buyer of Options, because you can expect a "reversal to the mean" effect and Implied Volatility to rise back to its mean levels, which seems to be between 25 and 30 - at least on this 6-month chart.

A higher Implied Volatility means higher Option prices. Take a look at the next two graphics for a comparison of Caterpillar (CAT) and Netflix (NFLX) Options taken some time in March 2012.

· Both stocks are trading at similar levels of 110

· The April series has 41 days to expiry

· For both stocks, the At the Money Options are at the 110 strike price

At this point in time, these two stocks are identical. But look at the 110 strike Options of both stocks for the same April expiry series.

· CAT 110 Calls are going for about $3.9 / share

· CAT 110 Puts are going for about $3.85 / share

· NFLX 110 Calls are going for about $7.95/share

· NFLX 110 Puts are going for about $8.85 / share

Why is this happening ? Two stocks are trading at the same price and have the same number of days to expiry for their Options, but NFLX Options are double the price of CAT. What is the reason ? The reason is Implied Volatility - the "wildcard". Look at the top right where there is a percentage number shown for both Option chains - this number tells you the Implied Volatility for that Options series. CAT's Implied Volatility is 29.5%, and now look at NFLX - it's 61%. NFLX Implied Volatility is double that of CAT. Therefore its Options are going to be priced double that of CAT. NFLX is simply a much more volatile stock than CAT, and therefore its Options are going to be more expensive because of its ability to "jump around".

Just because NFLX volatility is 61%, it does not mean you can't buy NFLX Options. You have to compare current levels of Volatility with its own Historical number before you make that decision. If NFLX historical number is 75%, then 61% would be considered "low volatility".

When you trade Options on any stock, its critical to study the current volatility of the Options and analyze if your strategy should be Vega positive or Vega negative, depending upon its current Volatility levels. When Volatility levels are high, it's generally a good time to sell premium and be "short" volatility i.e. you're expecting volatility levels to come down and benefit from a negative Vega strategy. When Volatility levels are low, it's better to get into strategies that are "long" volatility i.e. you expect volatility to increase and benefit from a positive Vega position.

For more information on these concepts, visit these links.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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