Two weeks ago when we parted company, I promised to delve into the topic of some of the tools that are available online for assessing volatility. We've already spent a fair amount of time looking at the volatility charts on www.iVolatility.com, but there is plenty more information available on that site. In fact, I dare say that site has a greater wealth of information available on the topic of volatility than any of us truly need. But it is a powerful resource for the nuggets of information that we find useful.
There is a neat little option calculator available on the site, which provides a nice complement to the historical and implied volatility charts. Recall that the historical volatility (HV) is a volatility measure on the stock, and the implied volatility (IV) is a measure of the aggregate or average implied volatility of all the options on that particular security, both puts and calls. While that's fine for determining whether it is a favorable climate for buying or selling options, when we get ready to actually implement a trade, we'd like to have more precise data on the specific option(s) that we are considering buying or selling. That's where the option calculator comes in.
Let's get everyone on the same page here, so that you can follow along on the site while we go through the example. Bring up the main page by typing in www.iVolatility.com. There is a line of links across the top of the page, beginning with Home and ending with Data Sales. The link we are interested is the one labeled Calculator. Click on that link and then after agreeing to the disclaimer page, you will be taken to a page with an option calculator. Here's what it looks like.
We're going to go through this exercise on the IBM example that we've been talking about since we began our journey into the subject of the Greeks over two months ago. Please make a note of the fact that I am writing this article on Thursday, March 28th, ahead of the holiday weekend for publication on April 3rd. So the actual numbers used in the examples here will be a bit stale. Hopefully that doesn't cause too much confusion, as it will make it far easier for me to enjoy my traveling this week.
We know from our recent work with the volatility charts that the volatility on IBM is currently near the lower end of its historical range. That means that the current climate in IBM favors option buyers, rather than option sellers. With IBM currently trading near $105, let's see what the calculator tells us about the Greeks on the May ATM put and call.
Enter IBM in the Symbol field at the top of the Calculator function, select the upper right Stock Symbol radio button and click on the check mark to fill in the fields in the calculator. Voila! The calculator fills in all the fields, telling us what the current price is, entering in the strike price that is closest to the money (in this case 105), front month (in this case April) expiration cycle is selected and then the application goes ahead and fills in the rest of the pertinent details. Days to expiration (DTE), Volatility % (this is the HV of the stock), Risk-free interest rate, and dividend data. That alone is some good information, but what we are really interested in is the data provided in the Put and Call columns.
In addition to providing us with the appropriate option symbols and their theoretical values, the calculator gives us values for Delta, Gamma, Theta, Vega and Rho. We haven't talked about Rho, which is related to interest rates, and is the one Greek that I tend to ignore. I don't consider it to be an important factor in the analysis of option pricing and I don't want to confuse the issue by trying to add it to the mix. But look at all that other good data we have to digest! This is a gold mine of information for those that know how to interpret the data, and that has been the focus of our attention here in this column for these past many weeks.
On the far left of the calculator page, there is an orange link, Calculators Help, which provides excellent step-by-step instructions on how to use and interpret each of the fields in the calculator. As you can see from the information provided in the online help, most fields in the calculator are filled in automatically, leaving us to focus on those that we are interested in. The inputs that we want to change of course are the Expiration Month and the Strike Price. So feel free to experiment, putting in different values for these fields.
Isn't it interesting to note that for the same strike price, Delta will change for different expiration months? That's right, Delta increases as the amount of time to expiration increases. That is one reason why a LEAP will move slightly faster with changing price in the underlying equity than will a front-month option. Do you notice any sort of a pattern in volatility as you change the expiration month in the calculator? Righto again! This is a very powerful piece of data, and it is our first glimpse at the concept of Volatility Skew. While we'll likely spend a couple of future articles talking about the intricacies of this concept, the basic idea is that different strike prices and expiration cycles of options on a given security will be priced differently due to differences in option-specific volatility. If we know what to look for, we can craft combination trades to take advantage of this inefficiency.
Coming back to the calculator, there is another interesting piece of information that you might not have noticed yet. As you go out further in time (say from April to September expiration), note that the values for Theta continue to decrease. This is a manifestation of the fact that time decay is slower in distant-month options and moves much more rapidly in front-month options. Look how much lower Theta is for both the Puts and the Calls in the graphic below (vs. the example above using front-month options), where we have selected JAN-03 as the expiration month.
If information is power, than I dare say many of you are feeling like you are ready to take on Tim, "The Tool Man" Taylor, of Home Improvement fame. But hold onto your horses, because next week we're going to cover another powerful online tool that can quantify our odds of success in any given option trade, based solely on current and expected prices and the present value of volatility. Doesn't that sound like a tool worth adding to your tool bag?
Oh, one last thing before I wrap this up. See that little Implied Volatility window lurking at the bottom of the Put/Call section of the Calculator?
Now that's really a handy little tool. We can enter in the price of an option, specify whether it is a put or a call, and the application will tell us what the implied volatility of that option is. That can give us an indication if the option we are considering is expensive or cheap in terms of volatility.
Until next week, happy exploring!