Last week I discussed what the basic inputs are to arrive at an option's premium. They are broken up into two categories: "intrinsic value" and "extrinsic value." Intrinsic value is the portion of the premium that is "in-the-money" and extrinsic value is the portion that is "out-of-the-money." The extrinsic value is comprised of "time until expiration" and "volatility." Since we know that time until expiration is easily calculated (each option has only a set number of days in its life), we don't need further discussion of that part. What I would like to discuss further is the tricky concept of volatility.
As many new traders dive into the world of options trading, they are consumed with the idea of making a killing. Just buy a few call (or put) options at a fraction of the cost of the underlying stock price and wait for the stock to move. That's all well and good if you have perfect timing. But since a majority of us don't have exact timing, we need to make sure that when we do buy or sell options, that we do it when the premium is at a favorable volatility level.
Most people don't even know what volatility is when it comes to options trading. You can be correct about the direction of the market and still lose money on your option contracts. This is due to bad timing, and/or not picking the correct strike price, and/or not taking volatility into consideration. Since we know that timing is easily figured by the amount of days left and picking the correct strike price is a matter of personal preference, we still need to figure how we can tell if volatility is allowing us to buy undervalued or overvalued options. This is what volatility tells us about an option - whether it's cheap, expensive, or fairly valued. Let's find out how.
Volatility as it applies to the marketplace is a term that describes the movement of individual stocks, indices, and options. The movements can be big, small, fast, slow, sideways, etc. Volatility gives us a way to measure those movements. There are two basic types of volatility: "historical" (or statistical) and "implied." Historical volatility (HV) tells us how the underlying stock or index has been moving over some period in the past. Each day's closing price of the stock or index is used in a calculation to give us the historical volatility figure. HV is quoted as a % number and can be figured for any amount of time you wish. Wall Street usually defaults to a 20-day or 30-day HV. It is like a moving average using each day's closing price as the inputs. HV gives us an idea of how the stock has moved in the past and how it can move in the future. If IBM has an HV of 55%, that tells us that over the next year we can expect it to fluctuate in a range of +/- 55% of its present price with a 68% degree of accuracy. If you want to see how IBM has moved over the last 30 days, then you would only use the most recent 30 days of data. There are places on the web where you can retrieve any stock or index's HV which can help you predict how the stock might move in the future. Needless to say, a stock with bigger fluctuations will have a higher volatility reading and vice versa.
"Implied volatility" (IV) is a number that corresponds with the options only. Each option on a stock or index has a component called IV. It is also a % number that tells us where the market thinks the underlying stock will move in the future over the life of the option. In essence, the option's market is making a prediction of where the stock will move. IV is also an indicator of expensiveness or cheapness of options. IBM's $100 call has an IV of 60% compared to its HV of 55%. This is telling us that the option's market thinks that IBM will move around more than what it has done in the past. Why? Maybe because its earnings are due very soon or because the Fed is meeting and nobody knows what the outcomes will be.
In most cases, HV and IV will be different and that's where the trading opportunities can occur. Some people like to compare HV to IV and this is how you tell if an option is cheap or expensive. Some sell options when IV is greater than HV and buy options when IV is lower than HV. That may work for some people, but I like to concentrate on using IV alone. I consider the professionals on the option's exchanges to have all the most recent and pertinent information regarding a stock's options, so I will use their prices as the most reflective of where the stock might go.
So what I do instead, is to compare current IV levels to past IV levels of the options. There are also places on the web that can give you past IV readings along with graphical analysis. What you will come to see is that each stock's options has a range that its IV has been trading in over some period in the past. Most of the information I use spans back two years in time. When the IV is currently much higher than its normal range, then I know that the options are currently very expensive for some reason. When the IV is currently much lower than its normal range, then I know options are relatively cheap compared to its past and option buying opportunities can exist. What usually happens is that over time, the IV will move back into its "normal" range after it has gotten really high or low. As the IV moves, it takes the option premiums with it. When IV is high, then premiums are high too. When IV is low, premiums are cheaper than normal.
Example: IBM $100 call with 55% IV = $10 IBM $100 call with 25% IV = $5
You can see that IV has an effect on the premium. This doesn't mean that 55% is overpriced or that 25% is underpriced. This is because we don't know what IBM's past IV levels have been. Say that IBM's past 2 year average IV has been 85%. This means that both of these options are undervalued when compared to IBM's past, except that one is MORE undervalued than the other.
If IBM's past 2 year average IV had been 45%, then the 55% option would be overvalued and the 25% option would be extremely undervalued. If you have a real-time data feed with good options data, the IV should always be available. But not all vendors will have the past IV levels.
This is the way that I price any option before I decide to buy or sell. My gauge is to always compare current IV levels to that of the past. Ultimately, the price of the stock on expiration day will decide if you are profitable or not on your position, but knowing whether you started out by buying or selling undervalued or overvalued options can increase your returns by a few points. If you bought an IBM $100 call at $5 when IV was at 70%, and IBM closes at $110, then you made $5. But if you bought that same call when IV was at 40%, then you might have only paid $2.50 for it and made a profit of $7.50. Even though you were correct in your direction of IBM's movement, the profit % could've been different. Now if IBM closed at $95 on expiration day, you would either have lost $5 or $2.50. So when you are wrong about the direction, your loss % can be different too.
That's it! I hope this helps some of you become more aware of what volatility is and how to use it to your advantage.