How Does Volatility Affect Stock Options?

Now that we’ve covered some of the more basic option strategies, it is time to introduce volatility. Volatility is a key factor when trading stock options. What exactly is volatility? And how does it affect stock options?

Defining Volatility

There are some very technical definitions of volatility, and if you’re interested in reading them you can at: http://www.investopedia.com/terms/v/volatility.asp. However, I would like to define volatility in a less technical way. If a stock tends to decline or appreciate in rapid bursts it is considered to be volatile. That is, we can expect the stock to move a decent amount (either up or down) percentage-wise during our time holding it. On the other hand, Blue chips and other slow moving stocks aren’t very volatile. They move with the market, and they don’t move very fast in either direction. Because some stocks are more likely to change prices rapidly their options are more expensive than those of a slow moving stock. However, there is a catch to this. At times you may notice a stock that hasn’t moved much at all recently, and yet their options are incredibly pricey! This stock might look like a good candidate to sell calls against, but doing so may be unwise.

Two Types of Volatility

Although, the previously mentioned stock may have seemed to be an incredible opportunity to write covered calls, there was likely another reason for the overpriced options that would put your position at risk. The market considers two types of volatility: historical and implied. Historical volatility is a measure of how volatile the stock has been in the past. This statistic can be very telling, especially when determining how much to pay for an option. However, implied volatility is what is actually used when pricing options. What is ‘implied’ volatility? Implied volatility is how much the market expects the stock to move over the life of the option. If a biopharmaceutical company is waiting for some huge drug decision by the FDA their options will be incredibly pricey; when the decision is finally made the price of the options will collapse, but their stock price may too. In a sense it is excitement that drives options to become overpriced. When the excitement is gone, your money is too! Be wary of overpriced options!

Next time we’ll talk about calendar spreads and learn more about volatility. After that I’ll introduce you to a few option pricing calculator and more complex strategies involving options.

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