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For the trader trying to understand options, it is
important to understand the two different concepts of volatility commonly
discussed with regards to stocks and their associated options. The importance
of understanding the concepts is that volatility in one of its two forms
plays a major role in the seemingly inscrutable machinations of options
pricing.
The two
types of volatility are referred to as statistical volatility and implied
volatility. The first type of volatility has little impact on options pricing
and is simply a mathematical expression of the magnitude of price variation
of a stock over a historical period. This form of volatility is obviously of
historic interest and does not reflect future expectations of future price
volatility.
The more
interesting volatility measure for an options trader is that of implied
volatility, often abbreviated as IV. Taken together with price of the
underlying and time to expiration, these factors form the three primal forces
of the options world. Since price of the underlying is familiar to all
traders, time to expiration is obvious to anyone with a calendar, and the
“stealth” component of these factors is implied volatility.
Implied
volatility is calculated by solving one of the several available options
pricing models for this variable. Since price of the underlying is known
precisely and the time to expiration is simple to determine, the equation can
provide the implied volatility necessary to produce the current price of the
option.
An
important characteristic of implied volatility is that it is forward looking
and reflects the aggregate opinion of future price volatility for the given
underlying. As such, it provides an important insight to help predict the
magnitude but not direction of future price movement.
Implied
volatility can be ignored only by those option traders with a death wish. As
an example of the danger of not understanding the impact of implied
volatility, consider a common story of a trader beginning to trade options.
Thinking
that earnings will be strong, he buys a front month at-the-money call option
looking to profit from correctly predicting price action after the release.
Following the earnings release, his call he owns reacts little if at all to
the price action. Common conclusion: the options markets are rigged and
controlled by insiders and offer no potential for profit.
The actual
cause of this less than optimal trade is a well recognized
and reliably predictable phenomenon that repeats every earnings cycle;
implied volatility almost always spikes as earnings approach reflecting an
anticipation of significant price volatility as a result of earnings release
and forward guidance.
As soon as
these data are released, implied volatility typically collapses as the
uncertainty surrounding this event has been removed. As a result, option
prices are significantly lowered and this collapse in volatility often
overwhelms correctly predicted price action and results in a flat or even a
losing trade.
Most
traders are familiar with the fact that the VIX is reflective of the implied
volatility of the SPX index. What is not generally as well known is that
individual stocks have historic databases of their implied volatility.
Consider for example the chart below presenting the daily historic and
implied volatility for the recent past in AAPL.
 
Several
things bear emphasis on the chart above. First, this database refers to
historic volatility as statistical volatility (SV)-
only the names are different. Second, notice that there is no consistent
relationship between historic and implied volatility; at times implied
volatility is higher than historic volatility and at other times lower.
Third, notice that there are distinct spikes in volatility. In general these
correspond to periods immediately before earnings release.
Other
spikes in implied volatility correspond with price decreases. Another
reliable characteristic of implied volatility is that it is inversely related
to price direction. The explanation for this phenomenon is that when price
drops traders scramble to buy puts and are willing to pay up for this
protection.
As a
result of the increased demand, price increases. The mathematics underlying
option pricing require parity between puts and call pricing, so the price of
the calls increase as well.
Another
typical characteristic of implied volatility is that it has a characteristic
range for a given underlying. This tendency can provide high probability
trading opportunities when volatility spikes well beyond its normal range as
a result of some event.
For
example, Chesapeake Energy recently exhibited a sharp selloff. Notice the
reaction of implied volatility of its options as traders rushed to buy
protective puts.
As a
result of this spike in implied volatility, I was able to sell Jun 10 puts, a
strike far away from the then current price of $15.29. This trade had a 94%
probability of profit at expiration. As price stabilized and implied
volatility came down, I was able to close the trade for a 78% realized profit
based on the funds encumbered by margin requirements.
Understanding
and accounting for the behavior of implied volatility is essential for the
options trader. Not to consider this factor in trades is a major error for
beginning option traders. In the future, refrain from making this very common
mistake.
Have a
safe and enjoyable Memorial Day Weekend!
JW Jones
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