Archive for June 17th, 2010

VOLATILITY IN OPTION TRADING Part 1 :)

We calculate an option’s theoretical value by using option pricing models, two of the primary, well know models are the ‘Black-Scholes Model’ and the ‘Binomial Model’. To compute the value minimum five of the option and its underlying’s related variables are required to be fed in these models; these five necessary inputs are the option’s exercise price, the time remaining to expiration, the current price of the underlying, the risk free interest rate over the life of an option and the volatility of the underlying.

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Out of the above mentioned inputs, volatility plays an important role in actual trading situations. Volatility is a statistical measurement of the degree of fluctuation of a market or security. Volatility is computed as the annualized standard deviation of daily percentage price changes of the security and is expressed as a percentage. Changes in our assumptions and marketplace assessments about volatility can have significant effect on an option’s value.

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Though the option traders are affected by the direction of the market, they are extremely sensitive to the speed of the market. This speed of the market is measured through volatility. In low volatility markets, the market of the underlying fails to move at a sufficient speed, and therefore, the options on that underlying will have lesser probability to achieve the option’s exercise price or the strike price within its expiry. But in markets which move quickly or in other words, in high volatility markets the market of the underlying is likely to move at sufficient speed and accordingly options on that underlying will have greater probability to achieve the option’s exercise price within expiry.

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Every Option trader is well acquainted with three types of volatilities- Historical Volatility, Forecast Volatility and Implied Volatility (IV). Historical volatility measures how volatile the security has been in the past. We compute historical volatility over a defined historical period, which is usually a twenty day period as it approximates the number of trading days in a month. Forecast volatility is an attempt to forecast directional moves in the price of the underlying, i.e. future volatility; it is usually calculated using time-series methods.

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Finally, implied volatility of an option contract is the volatility implied by the market price of the option derived from an option pricing model. In other words, it is the volatility that, when fed in a particular pricing model, yields a theoretical value for the option equal to the current market price of that option. This means it is possible to have a unique implied volatility for each given market price of an option. This implied volatility is best regarded as a rescaling of option prices which makes doing comparisons between different strikes, expirations, and underlyings easier and more spontaneous.

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