Lesson 5: The Volatility

The Volatility, implied volatility, historical volatility

The Volatility, implied volatility, historical volatilityAfter seeing in the article of last week the elements that affect the Premium, now I will focus on one of these aspects, the volatility. It is, as you have seen, the most elementary element that affects an option and represents the price change of an underlying (stock, index, commodity, etc.) over a given time interval. The more the volatility is high, the more the value of the option increases.

It is always referring to the underlying and is divided into:

1. Implied volatility represents the expectation of the operators on what the future volatility of the underlying will be. If the implied volatility is high, it means that we will soon expect a strong upward or downward movement of the underlying. Conversely, if it is low, it is expected that the underlying will not move much in the future.

2. Historical volatility indicates how much the underlying has moved in the past. It, therefore, refers to something that has already happened.

Implied volatility is the one that measures nervousness on an underlying and is the one that affects the value of the premium. When implied volatility is higher than historical, it means that the market expects that shortly the underlying will move more than it did in the past.

But how does volatility affect the value of options? Two situations dictate the value of the options:

1. Intrinsic Value: it is the difference between the underlying's price and the strike price (or the in-the-money portion of the option's premium). Specifically, the intrinsic value of a call option is equal to the underlying price minus the strike price. For a put option, it is the strike price minus the underlying price;

2. Extrinsic Value: it measures the difference between the market price of an option and its intrinsic value. The extrinsic value is linked to factors that do not depend on the performance of the underlying, i.e. the expiring of the option and the volatility.

Total Option Value = Intrinsic Value + Extrinsic Value

The elements that determine volatility are:

1. Earnings. Most importantly, American companies are required to issue a series of data on the company's performance every three months. Depending on the data, we can witness significant fluctuations, even with several percentage points in a single day.

In proximity to the earnings, volatility begins to grow because the market knows that when earnings come out, the stock could move heavily up or down. For this reason, it is not advisable to buy options before earnings because we will pay a much higher premium (in addition to the fact that earnings can very negative).

2. Rumours. Another element is the market rumours that may alter the price of an underlying asset. Voices of acquisitions, capital increases… certainly create nervousness in the markets, thus increasing volatility.

3. Panic Selling. Following corporate, economic and political events, particularly serious and important it can follow strong sales by all investors, causing panic selling, resulting in a sharp increase in volatility.

Just think about what happened after September 11 or the Volkswagen stock the day after the news of the "diselgate" (-18.60%). In either case, volatility went through the roof.

Other factors that cause increased volatility are macroeconomic data, central bank meetings and interest rate decisions (higher interest rates lead to somewhat higher option prices, and lower interest rates result in lower option premiums), tensions between major oil producing countries and all that can cause nervousness and uncertainty in financial markets.

Very important rule to keep in mind: volatility rises when the markets go down while it goes down when the markets go up.

Next week we will see another important aspect of the options: the time.


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