Understanding Historical and Implied Volatility - A Comprehensive Guide

1. OC Traders02/28/09 Orange County Investools Users Group

2. Volatility after the Options Industry Council’s Workshop on Volatility

3. Volatility Reflects Price Changes • Volatility reflects fluctuations in the price • Not necessarily an uptrend • Not necessarily a downtrend • Greater fluctuations = greater volatility Rowena St.Moritz

4. Volatility Two Types of Volatility • Historical Volatility • Implied Volatility Rowena St.Moritz

5. Historical Volatility

6. Historical Volatility • Past volatility, usually annual • An observed fact, not a prediction • Is no guarantee of future volatility • Usually based on daily closing prices Rowena St.Moritz

7. Historical Volatility • Annualized Standard Deviation (SD) of daily price changes, expressed in percent • The percent amount is relative change, up or down, from the average price • Stocks, options, indexes and sectors have historical volatility Rowena St.Moritz

8. Historical Volatility • Annualized Standard Deviation (SD) of daily price changes, expressed in percent • Prices within 1 SD ~ 68% of the time • Prices within 2 SDs ~ 95% of the time • Prices within 3 SDs ~ 99% of the time Rowena St.Moritz

9. Historical Volatility Illustration • If a stock has an average closing price of $100 and 25% historical volatility, then statistically ~ 68% of the time (1 SD) Price was within + or - $25 ($75 to $125) ~ 95% of the time (2 SDs) Price was within + or - $50 ($50 to $150) ~ 99% of the time (3 SDs) Price was within + or - $75 ($25 to $175) Rowena St.Moritz

10. Historical Volatility • Available at http://www.optionseducation.org/quotes/ • Enter the equity symbol • Click on “Historical Volatility” Rowena St.Moritz

11. Historical Volatility Example • Example for IWM on 2/22/09 http://www.optionseducation.org/quotes/ Rowena St.Moritz

12. Historical Volatility Indexes, Sectors, Stocks, and Options have it • Some sectors may have lower or higher volatility levels, but… • Volatility often changes, even when spread across sectors or indexes • Volatility of stocks within sectors may vary Rowena St.Moritz

13. Implied Volatility

14. Implied Volatility • Implied volatility is what people often mean when they just say “volatility” • It is expected volatility, a guess • It is a subjective prediction • It is an assumption about a stock’s volatility up to the option’s expiration Rowena St.Moritz

15. Implied Volatility • By definition, it implies a stock’s future volatility, but… • Implied volatility is a feature only of options Rowena St.Moritz

16. Implied Volatility Only Options Have It • Stocks do not have implied volatility Stocks have historic volatility only • Options do have implied volatility • Calls have implied volatility • Puts have implied volatility Rowena St.Moritz

17. Implied Volatility • Can be at great variance with historical volatility • Is not necessarily right or wrong • May change abruptly and significantly • An option’s implied volatility can change without a change in the underlying stock’s price Rowena St.Moritz

18. Implied Volatility • Predicts a range of future possible stock prices • Higher volatility = greater range of possible stock prices • Lower volatility = smaller range of possible stock prices Rowena St.Moritz

19. Implied Volatility Example • Example for IWM on 2/22/09 http://www.optionseducation.org/quotes/ Rowena St.Moritz

20. Implied Volatility • Index Options’ Implied Volatility Symbols • S&P 500 30-day implied volatility VIX VIX is what people usually mean by “the” volatility index • Dow Jones Industrial Avg 30-day implied volatility VXD • Nasdaq 100 30-day implied volatility VXN • Russell 2000 30-day implied volatility RVX Rowena St.Moritz

21. Implied Volatility • Index Options’ Implied Volatility Rowena St.Moritz

22. Implied Volatility S&P 500 30-day implied volatility VIX Rowena St.Moritz

23. Implied Volatility Dow Jones 30-day implied volatility VXD Rowena St.Moritz

24. Implied Volatility Nasdaq 100 30-day implied volatility VXN Rowena St.Moritz

25. Implied Volatility Russell 2000 30-day implied volatility RVX Rowena St.Moritz

26. Implied Volatility Things that affect implied volatility • General stock market psychology • Economic data, Federal Reserve actions, and other news • Change in the implied volatility of other option classes within the same industry sector • Market activity (volume) Rowena St.Moritz

27. Implied Volatility Things that increase implied volatility • Rising volume • Drop in price • Bad news • Nearing an announcement (e.g. earnings) Rowena St.Moritz

28. Implied Volatility Things that decrease implied volatility • Declining volume • Rise in price • Good news • After an announcement (e.g. earnings) Rowena St.Moritz

29. Price and Implied Volatility

30. Price and Implied Volatility An Option’s price has two components • Intrinsic value • Time value Rowena St.Moritz

31. Price and Implied Volatility Option’s Time Value • Time until expiration (known) • Cost of money (known or predictable) • Interest • Dividends • Volatility (unpredictable) • As the cost of money approaches zero, volatility is a greater portion of time value Rowena St.Moritz

32. Price and Implied Volatility • Implied Volatility = Risk • Implied Volatility affects option premium • Higher volatility means higher option premium • Lower volatility means lower option premium Rowena St.Moritz

33. Price and Implied Volatility • Higher volatility • Sellers want more for their increased risk • Buyers pay more • Lower volatility • Sellers take less for their decreased risk • Buyers pay less Rowena St.Moritz

34. Price and Implied Volatility • As stock volatility increases, the price of calls and puts generally increases • As stock volatility decreases, the price of calls and puts generally decreases Rowena St.Moritz

35. Price and Implied Volatility • If you are long a call or a put, then you want the option’s implied volatility to increase so that the option’s price will go up • If you are short a call or a put, then you want the option’s implied volatility to decrease so that the option’s price will go down Rowena St.Moritz

36. Price and Implied Volatility Implied Volatility’s Effect on Options • Greatest nominal (dollar) effect on ATM Calls and Puts (because they have the greatest time value) • Greatest percentage effect on OTM Calls and Puts • Least effect on ITM Calls and Puts because they have so little time value Rowena St.Moritz

37. Vega and Implied Volatility

38. Vega and Implied Volatility Vega is “one of the Greeks” • Vega is theoretical - in reality, price changes may differ from those predicted by Vega • Vega’s value decreases with time • Stock has zero Vega Rowena St.Moritz

39. Vega and Implied Volatility • Vega is expressed in dollars/cents • Shows expected option price change for a 1%-point change in implied volatility • Can be expressed per option or per contract • Spreads and other complex positions have a net vega (positive for long positions and negative for short positions) Rowena St.Moritz

40. Vega and Implied Volatility Illustration of Implied Volatility’s relationship to Vega • $80 Call is $3.50 ($350 per contract) • Implied Volatility is 35% and Vega is $.15 • If underlying equity’s price remains unchanged • If Implied Volatility rises 1 point, the contract price is expected to rise $15 to $365 • If Implied Volatility falls 1 point, the contract price is expected to fall $15 to $335 Rowena St.Moritz

41. Vega and Implied Volatility Example for IWM on 2/22/09 at ThinkOrSwim Rowena St.Moritz

42. Vega and Implied Volatility Explanation of Example for IWM on 2/22/09 at ToS • $40 IWM March Put is $1.815 • Implied Volatility is 52.35% • Vega is 4.31 per contract or $.0431 for the option • If IWM’s price is unchanged and Implied Volatility • Rises 1 pt, contract price is expected to rise to $185.81 • Falls 1 pt, contract price is expected to fall to $177.19 Rowena St.Moritz

43. Vega and Implied Volatility Vega’s Bell Curve • Vega is greatest on ATM Calls and ATM Puts (because they have the greatest time value) • Vega is smaller on OTM Calls and OTM Puts • Vega is smallest on ITM Calls and ITM Puts Rowena St.Moritz

44. Conclusions

45. Conclusions Buy Low and Sell High • Refers to volatility as well as price • Sell options during high volatility • Buy options during low volatility Rowena St.Moritz

46. Conclusions Buy Low Volatility and Sell High Volatility • If earnings are coming out and the stock’s volatility is up • You believe that the stock’s price will skyrocket after the earnings announcement • You want to buy a Call to profit from the price increase • Consider selling a Put, instead of buying a Call • You can buy back the Put right after volatility drops • Even if the stock’s price doesn’t rise, you may profit from decreased volatility – you can be wrong and still profit Rowena St.Moritz

47. Conclusions Thinkorswim’s recommendations on volatility • When volatility is low and rising • Purchase Calendar Spreads • Purchase Double Diagonal Spreads • When volatility is high and falling • Sell Iron Condors • Sell Vertical Spreads Rowena St.Moritz

48. The End