OPTIONS
Ride The Tide Of VolatilityThe Third Dimension
Of Option Tradingby Don A. Singletary
Here's how you can profit from trading volatility.
Sometimes when you purchase an option, you might see the underlying futures contract move in your favor, perhaps enough to overcome the time decay of the value of the option, and then you might find yourself bewildered that a profit has yet to be realized. Other times you may be awaiting time-decay erosion, only to find it is a much slower decay than anticipated. More often than not, these situations are due to a change in volatility.
Time decay works to your advantage if you are short options and it can be detrimental if you are long; volatility has the opposite effect. Since volatility is an unknown factor in options trading many neophytes disregard it, but experienced professionals who use volatility as a tool can trade it. When you buy options you are long volatility and when you sell options you are short volatility. Even if you do not wish to trade volatility, you must have some understanding of it in order to diminish its effects.
OPTION VALUATION
The intrinsic value of an option is simply a function of how much the option is in or out of the money and is not subject to speculation. The extrinsic value includes the time value and the value of implied volatility. The extrinsic time value of the option can be accounted for as a function of exactly how many days until expiration. Volatility, the other part of extrinsic valuation, is a major portion of the option's pricing, but is not so quantitative and is much more difficult to determine.
Volatility is the third dimension, or (in William Shakespeare's terms) the Òundiscovered countryÓ of option trading. It can be a helpful tool for selecting the types of option trades, the timing, and the strike price of each option. Ignoring it can be fatal to a trade.
VOLATILITY
Generally, two categories of volatility are defined -- historical and implied. Historical volatility is an annual record of price fluctuations expressed as a percentage of standard deviation. It is stated with hindsight and absolute accuracy. Implied volatility is what gives an option its current value. As the underlying makes a move, buyers of the option create higher demand for puts and calls because they think they are more likely to make money. Likewise, the sellers of options realize it will be riskier for them to sell options during times of volatile prices and so they demand higher prices. Historical volatility is sometimes viewed in conjunction with seasonal price changes to correlate seasonal volatility with the implied volatility, especially with agricultural options. Trading opportunities could exist when the implied volatility is far above or below its seasonal average with no apparent cause.
There is no precise and generally accepted method of deriving the future implied volatility in the pricing of options.
...Continued in the January 2002 issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the January 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2001, Technical Analysis, Inc.
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