Volatility

If you are unfamiliar with the concept of volatility, you might want to review the previous section on pricing options.

Implied Volatility

Before we examine the ways professional traders use volatility in conjunction with theoretical pricing models, it's important to note that these calculations are all done by computer programs. What typically happens is that traders plug their volatility assumptions into the computer and have instant access to theoretical option values at a wide range of stock prices.

Although not all traders rely on models, those that do use a volatility assumption, usually based on a historical value, as a barometer for where they believe options should be trading. At the same time, traders monitor the actual market prices to determine what is known as implied volatility. By plugging real-time option prices into a theoretical model (instead of a volatility assumption), the same equation can be used to calculate the volatility of each option. For example, while the 90 day volatility of a stock may be 25%, the current option prices may imply higher or lower volatilities even for the same expiration month.

Stock XYZ Corp:

Price $54 per share
Historical Volatility: 25%

Option	Implied Volatility
Sep 40 call	18%
Sep 45 call	23%
Sep 50 call	38%
Sep 55 call	42%
Sep 60 call	27%
Sep 65 call	29%

Some professional traders have sophisticated programs that continually monitor the implied volatilities of every exchange traded option looking for options that are significantly underpriced or overpriced relative to their historical volatility. These options are then either bought or sold and hedged against other options or stock. In the example above, if a program determined that the volatility of the September 55 call (42%) was statistically significant relative to other options, the trader might decide to sell the 55 calls and buy the 40 or 45 calls as a hedge.