One of the principal factors affecting an option's value is the volatility of the underlying stock or index. Although volatility is a complex topic, traders without knowledge of the way this variable affects option pricing and potential risk have little chance of surviving in the derivatives market. With this fact in mind, the objective of today's narrative will be to provide some background on volatility and explain how it can be used to identify favorable option positions.
By definition, volatility represents the magnitude of movement of a particular issue over a given period of time. In more practical terms, volatility reflects how the price of the underlying issue has reacted in the past, as well as how it is expected to change in the future. The components that help forecast this activity are both historical (statistical volatility) and market-driven (implied volatility). An increase or decrease in either one of these factors will generally affect the value of the option, as long as all other variables remain the same.
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Statistical (or historical) volatility is based on past movement and it simply reflects how far an issue has deviated from its average (mean) price over certain periods of time. In contrast, the calculation to determine implied volatility starts with the option's price and works backward to establish a theoretical value that is equal to the current market price minus any intrinsic value. It is a computed number that has more to do with the option's future potential, as opposed to the price of the underlying asset. From a laymens viewpoint, implied volatility is the volatility value that makes an option's fair value equal to its present price in the open market.
Some traders refer to implied volatility as "premium" even though that term actually relates to the extrinsic value of an option. Since intrinsic value describes the in-the-money portion of an option's price, extrinsic value is simply the difference between this amount and the option's current market price. Of course, implied volatility and premium are interconnected in one respect; an increase in implied volatility will raise an option's premium, without regard to other price-related components.