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Value Of Knowing Implied Volatility From Security Prices

Value of knowing Implied Volatility from Option Prices

Investors categorize stocks based on Market cap- Small cap or Large Cap, Type- Value or Growth stocks, Domestic stocks or Emerging Markets. In various analyst reports there are numerous data about EPS, Book Value, Growth, Dividend, prospects etc. There are various theories which of the categories are risky or safe, some years it is perceived high market price to book value or high PE stocks are risky. Of the various information that is missing in these reports-is the implied volatility derived from the options price on the stocks. May be it is complicated to understand the calculation or explain to investors.

Volatility is a variable that is used in Black Scholes Options model to derive the option prices. Implied volatility tells us of the number that is implied based on current market price of stock and the option price. In simple English Implied Volatility basically tells what markets participants expects the stock prices to move in either direction over a given time.

For example JPM's implied volatility is in early 20s, Apple's implied volatility is in early 30's and Netflix is in late 40's over 1 year. So these stocks can go up or down by these percentages most of the times. There is a debate on market efficiency model, necessary to work for the implied volatility. Market efficiency can be debated in some other blog.

Invariably the stock prices will move in either direction and that swing will be much more or less than the implied volatility in the option prices. However it does tell of the range of movement of security based on current market sentiment.

Most investors generally don't know what range of prices that security may fetch over a given period. They have a target price, but don't know what the downside in investing in a particular stock is. Investors can benefit by knowing and including the implied volatility in the option price as an additional factor in their analysis of securities.