Volatility & Equity Options

Successful equity option trading requires opinions on three variables concerning the underlying stock: expected price direction, timing of the expected move, and the stock's future volatility. Although most investors appreciate the importance of a formed opinion on price movement and timing when selecting an option, it is consideration of the stock's future volatility that is usually ignored or not understood.

What is volatility? Mathematically, volatility is the annualized standard deviation of daily returns. A simple definition, however, is the fluctuation of stock prices without regard to direction. Big average daily stock price changes (up or down, in percentage terms) means high volatility, and small average daily price changes means low volatility.

To be able to make a forecast of a stock's future volatility we need to have an understanding of the role that volatility plays when pricing an option. The easiest way to accomplish this is comparing the pricing of an option contract to the pricing of an insurance contract.

Options can serve as insurance policies? In a manner of speaking, yes. Just as the insurance policy owner desires to transfer the risk of owning real property to someone else at a fee, an investor can purchase an option contract to protect their cash or stock positions against market fluctuations by paying a premium to someone else to assume the risk. Because of the leverage options convey, many investors assume they are meant only for speculation. By definition, however, options are instruments of risk transfer. They evolved because of a need for protection, or insurance, against wild price fluctuations in agricultural markets. To understand further how options work as insurance products, consider the following two examples.

Through the purchase of equity puts on a share-for-share basis with owned stock, an investor has the right to sell the underlying stock at a fixed price for a specific length of time. This right to sell may protect the owner of the underlying stock against a decline in price until that option's expiration. By purchasing equity calls, an investor has the right to buy the underlying stock at a fixed price for a specific length of time. This right to buy may insure a cash position against a price increase in the underlying stock until the option's expiration. Although the put protects against a "real loss" and the call against an "opportunity loss," both types of options may protect an investor from unfavorable events, acting as insurance polices in every respect.

To continue the comparison, both the insurance company and the options marketplace must consider risk when establishing a contract's premium. Insurance companies hire actuaries to evaluate the potential risk of writing policies. When would an actuary's job be the most difficult? Consider an actuary sitting in a client's home with a hurricane expected to arrive in hours trying to evaluate the risk factor for the homeowner's policy. In this case, the actuary could justify inflating the policy's premium because of the potential for damage that the hurricane's winds pose. If the hurricane suddenly diverted its course away from the house, the risk would diminish considerably and the actuary might price the policy at a more modest level.

As with an insurance policy, potential risk is considered in the pricing of an option contract; however, the risk comes from the possible price fluctuations of the underlying stock, i.e. its volatility. A market maker pricing that option in the marketplace makes a forecast of the stock's future volatility.

When might pricing an equity option be difficult? Imagine a market maker pricing an option on the underlying stock of a company expected to announce earnings the next week. A discrepancy between the analysts' expectations and the announced earnings could cause the stock price to fluctuate dramatically. The market maker might inflate the option's premium in order to offset this potential volatility risk. If after the earnings are announced there is reduced uncertainty about future stock price changes, the market maker could justify lowering the option's premium.

Taken to another level, volatility can be considered three ways. First, there is historical volatility, which is simply the measure of actual stock price fluctuations in the past. Second, there is forecasted volatility, or an estimate of the future volatility in an underlying stock. Third, there is implied volatility, or the volatility assumption that results in the actual price of an option in the marketplace. It reflects a consensus of the marketplace as a whole on the forecasted volatility of an underlying stock.

Using this new vocabulary let's apply it to an example. Companies which are in the headlines are frequently the favorites of speculators buying options. When doing so many will have opinions on just price direction and timeframe, and pay little attention to implied volatility. Consider this scenario.

With the historical volatility of XYZ stock at 27%, a XYZ 30-day at-the-money call option was initially trading at an implied volatility of 25%. However, because of a recent 2 for 1 stock split announcement by XYZ, the implied volatility of the option contract had risen to 40%. As a result of this increase, the option contract, which previously traded for $1 �, or $150, was now trading for $2 �, or $250. News of the split prompted a speculator to purchase this option with the expectation of reselling the contract at a 100% return on investment in a week's time. However, the speculator did not consider implied volatility and paid $250 for an option contract which had historically been trading for $150. In this case, after the initial reaction to the news subsided, the implied volatility returned to historical volatility levels, resulting in a decrease in the option's premium. Although fluctuation in an option's premium is often the result of movement in the stock price, the fluctuation of this option's premium was the result of movement in its implied volatility. Because of implied volatility fluctuation, the speculator must now wait for a larger movement in the stock's price to reach the investing goal of 100% return.

Understanding how volatility affects option premiums enables traders to complete a three-part forecast: expected price direction of the underlying, timing of the expected move, and the stock's future volatility. Although there is no guarantee that a forecast will be correct, including a prediction on the stock's future volatility in the decision-making process gives traders an improved chance of achieving their intended results.