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Educational Article

Varying Views on Volatility

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It seems that hardly a day goes by where we don't hear some comment on CNBC or here in the various columns in our own newsletter talking about the low levels of broad market volatility, VIX.X for the S&P 100 (OEX.X) and VXN.X for the NASDAQ-100. Eric has been making a series of interesting observations on these two measures of market volatility in his Market Sentiment column recently, including the possibility that these measures may be moving into a new, lower range.

But our interest in volatility has been more focused on the micro level in this column, where we are looking at equity-specific volatility levels, using that information to formulate a workable trading plan. It took us awhile to get through it all, but in my mind, we have now covered the basics on all the Greeks that influence the pricing of options. We've gone through some examples of how to utilize the data on Delta, Gamma, Vega and Theta to formulate a solid trade, but we've really just focused on the basics up to this point. If you missed any of my prior ramblings on the subject of the Greeks, all of the articles are stored for posterity in the Options 101 archives. Since I'm such a nice guy (BIG GRIN), I'll give you a shortcut, listing all the links to the articles in the series right here.

The Greeks, Part I - Delta and Gamma
Application of Gamma and Delta to Strike Selection
Back to the Olympians of Old
Oh, That Vexing Volatility
Volatility - Part Deux
The Greeks - Putting It All Together
A Greek Encore

We've talked a lot about the theory and practice of using volatility analysis to pick attractive options to buy or sell, but while perusing some old articles over the weekend, I found an example that I think really illustrates the concept of volatility. Let's look at two different stocks, both trading near the $50 level, Philip Morris (NYSE:MO) and Applied Materials (NASDAQ:AMAT). Assuming we are bullish on both stocks, let's look at option prices for the two stocks.

As I write this, MO is trading at $52, and AMAT is trading at $51.35, so that should be close enough to make a fair comparison. The May $55 Call for MO is currently trading for $0.70, while the May $55 AMAT Call is fetching $2.50. What's going on here is little more than volatility. AMAT has a far more volatile trading pattern than MO, and this "risk premium" is factored into the option price through volatility. This isn't to say that MO would make a good call play and AMAT would make a bad one. In order to make that kind of determination, we would first have to go look at the historical volatility charts over on www.iVolatility.com, which show that both AMAT and MO are currently near the lower edge of their historical volatility range.

While both AMAT and MO are currently trading near the bottom of their historical volatility ranges, note the difference in their respective ranges over the past year. IV for MO has ranged between 20% on the low end and 47% on the high end, while AMAT has a much higher range, between 42% and 116%. That difference in volatility is the reason for the large discrepancy between the slightly OTM options on the two stocks. This volatility information tells us that odds favor the option buyer here, rather than the option seller, due to the fact that the options will be relatively cheap. Any increase in volatility would increase the volatility premium of the options -- good if you bought those options, but bad if you sold them. We've gone into that issue in some of our prior articles, so I won't belabor the point here today.

Coming back on track, the way to think of volatility in terms of its impact on option prices is that it represents the factoring in of statistical probabilities into the option pricing model. AMAT has a higher probability of moving a given distance (either up or down) due to the fact that it has done so in the past. Now we know that past performance is no guarantee of future results, but we have to start somewhere.

There are probability calculators available online that will allow us to use the current price and volatility of a given stock to calculate the odds of success (profit) and we'll delve into some of those tools next week. For those of you that would like to get a headstart, here are a couple of the tools I'll be talking about next. First up will be the options calculator on the iVolatility.com site, which can be accessed from the Calculators menu selection across the top of the home page. After covering the use of that tool, I want to delve into what I think will be an even more eye-opening tool, an actual probability calculator. Don't you think it would be useful, before opening an option trade, to see what the odds of success are? Tune in next week and we'll have some more fun!

And don't worry, I haven't forgotten my promise to delve into the topic of volatility skew. I just think it is a fairly complex concept and I want to finish laying out some of the more basic concepts before tackling that one.

Questions are always welcome!


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