Jun 30, 2010


Volatility is the property of a stock that describes its tendency to undergo price changes.  More volatile stocks undergo larger or more frequent price changes.  

Outside the options world, volatility is described by the term beta, which is a measure of the relative volatility of a specific stock, when compared with the volatility of a large group of stocks (often the Standard & Poor's 500 Index). A beta of 1.0 means the stock has the same volatility as "the market" as a whole. Stocks with beta values less than 1.0 are less volatile than the market, while stocks with beta values greater than 1.0 are more volatile. Beta is useful because it allows an investor to estimate the price movement of his/her stock, compared with the overall market.

When we deal with stock options, we must know the volatility of the stock as a stand alone item. Comparing its volatility to that of other stocks is of no use in determining how its options should be priced.  Why?  Because it's important to calculate the chances that the stock will move beyond any given strike strike price before the options expire. When measuring volatility of a specific stock, a statistical analysis is made using daily price changes. This volatility measurement is unrelated to beta, except that stocks with higher beta values have higher volatility.

In the options world, volatility is measured as a percentage, and price changes are measured from one day’s closing price to the next. To put it into familiar terms, when a stock is described as having a volatility of 30 (Volatility = 0.30), it means the stock moves (either up or down) by 30% or less, approximately 2 years out of every 3.  A move twice that size (60% in this example) occurs about once every 20 years.

Volatility is of interest to option traders because it's a vital factor in determining the market price of options. Option buyers make money when stocks undergo significant price changes (if the change is in the correct direction).  Because volatile stocks are much more likely to undergo large price changes, option buyers pay a much higher premium for options of volatile stocks.  As a result, the options of similarly priced stocks often have vastly different premiums. 

As an example, let's look at a stock priced at 50.  

Consider a 6-month call option with a strike price of 50:
  • If the implied volatility is 90, the option price is    $1250
  • If the implied volatility is 50, the option price is      $725
  • If the implied volatility is 30, the option price is      $450
The implied volatility represents the best (current) estimate for the future volatility of the underlying stock - from the current time through expiration.

These premiums are very different.  That's why a trader cannot simply go out and buy an option.  It's important to know whether the option price is reasonable.

Mark D Wolfinger

Expiring Monthly: The Option Traders Journal