How Volatility Affects Option Prices - dummies

How Volatility Affects Option Prices

Volatility, a measure of how fast and how much prices of the underlying asset move, is key to understanding why option prices fluctuate and act the way they do. In fact, volatility is the most important concept in options trading.

There are two kinds of volatility: implied volatility (IV) and historical (or statistical) volatility (HV). Whereas HV measures the rate of movement in the price of the underlying asset, IV measures the price movement of the option itself.

  • Implied volatility (IV): This is the estimated volatility of a security’s price in real time, or as the option trades. Values for IV come from formulas that measure the options market’s expectations, offering a prediction of the volatility of the underlying asset over the life of the option.

    Another way of looking at it is that IV is the volatility implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, given a particular pricing model, yields a theoretical value for the option equal to the current price. It usually rises when the markets are in downtrends and falls when the markets are in uptrends.

  • Historical volatility (HV): Also known as statistical volatility (SV), this is a measurement of how fast prices of the underlying asset have been changing over time. Because HV is always changing, it has to be calculated on a daily basis. It’s stated as a percentage and summarizes the recent movements in price. In general, the bigger the HV, the more an option is worth.

Volatility can be difficult to grasp unless taken in small bites. Fortunately, trading software programs provide a great deal of the information needed to keep track of volatility. Bare-bones screening software is available for free from The Options Industry Council.

For more sophisticated analysis, you have to spend some money. Many good options-trading programs are available. Among the most popular programs is OptionVue 5 Options Analysis Software, which has just about everything you could want to analyze options and find trades. Many traders use OptionVue and consider it the benchmark program.