Option Volatility
An essential element determining the level of option prices, volatility is a measure of the rate and magnitude of the change of prices (up or down) of the underlying. If volatility is high, the premium on the option will be relatively high, and vice versa. Once you have a measure of statistical volatility (SV) for any underlying, you can plug the value into a standard options pricing model and calculate the fair market value of an option.
Implied Volatility: A measure of the volatility of the underlying stock, it is determined by using prices currently existing in the market at the time, rather than using historical data on the price changes of the underlying stock.
Statistical (Historical) Volatility: The annualized standard deviation of percent changes in futures prices over a specific period. It is an indication of past volatility in the marketplace.
A model’s fair market value, however, is often out of line with the actual market value for that same option. This is known as option mis-pricing. What does this all mean? To answer this question, we need to look closer at the role IV plays in the equation.
What good is a model of option pricing since an option’s price often deviates from the model’s price (that is, its theoretical value)? The answer can be found in the amount of expected volatility (implied volatility) the market is pricing into the option. Option models calculate IV using SV and current market prices.
For instance, if the price of an option should be three points in premium price and the option price today is at four, the additional premium is attributed to IV pricing. IV is determined after plugging in current market prices of options, usually an average of the two nearest just out-of-the-money option strike prices.
To view historical and implied volatility for specific stocks, ETFs, and more, please visit iVolatility.com. Stock options analytical tools for investors as well as access to a daily updated historical database on more than 10,000 stocks and 300,000 options.
