Options
When we talk about options pricing, the concept of volatility comes up immediately. This is because volatility is a core concept in trading and investing, yet it’s often misunderstood. Many traders, especially beginners, conflate volatility with the direction of a stock’s price movement, assuming high volatility signals a strong trend, either upward or downward. However, this is a misconception. Volatility is not about the direction of price movement but about the magnitude and frequency of price fluctuations over a given period. A stock can be highly volatile with rapid price swings in both directions or relatively stable with minimal changes, regardless of whether its overall trend is up, down, or sideways.
Volatility measures the degree of variation in a stock’s price over time. It reflects how much and how quickly a stock’s price changes, capturing the uncertainty or risk associated with the asset. For example, a stock with 20% annualized volatility is expected to have price movements within a range of ±20% of its current price over a year, with about 68% probability (assuming a normal distribution). Volatility is agnostic to direction. A stock that jumps from $100 to $120 and then drops to $80 is just as volatile as one that falls from $100 to $80 and then rises to $120. The key is the size and speed of the price swings, not the net change. This distinction is critical because traders who misinterpret volatility as a directional signal may misjudge risk or opportunity. In options trading, the most important type of volatility you need to concern yourself with is implied volatility.
Implied volatility(IV) is a forward-looking measure derived from the current prices of options. It reflects the market’s expectations of how volatile a stock will be over the life of the option, as implied by the option’s price. Unlike historical volatility, which is backward-looking, implied volatility is a market-driven estimate of future price fluctuations.
Example: If an option on Stock A has an implied volatility of 40%, the market expects the stock to be more volatile over the option’s life than its historical volatility of 25% would suggest. This could be due to an upcoming earnings report. If the event passes and volatility drops, the option’s price may decline, even if the stock price remains unchanged—a phenomenon known as “IV crush.”
As I briefly mentioned earlier, implied volatility is a critical concept in options trading, serving as a measure of the market’s expectations for a stock’s future price fluctuations. Unlike historical volatility, which looks at past price movements, implied volatility is forward-looking and derived from the prices of options in the marketplace. Implied volatility does not emerge from thin air. It is a market-derived metric that reflects the collective expectations of traders about a stock’s future price volatility over the life of an option. These expectations are embedded in the prices of options, which are determined by supply and demand in the options market.
IV originates from the options market, where traders’ actions set option prices through supply and demand. When traders anticipate significant price movements—say, due to an upcoming earnings report, a court ruling, or a product launch—they buy more options to capitalize on the expected swings. This increased demand pushes option prices higher, specifically boosting the time value, which is the part of an option’s price tied to its future potential. The intrinsic value, which reflects the option’s current profitability, remains unaffected by IV. For example, if a company’s earnings are nearing, traders might expect a big move, driving up the price of a $100 call option because they see a wider range of possible stock prices, like $90 to $110. Conversely, if traders expect stability, they may sell options, lowering prices and reducing the time value. IV is then calculated from these option prices using models like Black-Scholes, which reverse-engineer the volatility needed to match the market price, given inputs like stock price, strike price, and time to expiration. Without an active options market, IV can’t be calculated, as there’s no price data to analyze.
The relationship between IV and option prices is dynamic and central to trading. When IV rises, option prices increase because the market expects larger price swings, making options more valuable. This benefits option buyers, who see their options gain value even if the stock price stays flat, but it hurts sellers, who face higher costs to close their positions. For instance, if IV jumps from 20% to 30% before an earnings report, a $5 call option might rise to $6, helping buyers but challenging sellers. On the flip side, when IV falls—often after an event resolves uncertainty, like an earnings “IV crush”—option prices drop, favoring sellers who can buy back options cheaper, while buyers lose value. Imagine that same call option dropping to $3 after earnings if IV falls to 15%, even if the stock moves slightly upward. This dynamic makes IV a double-edged sword, as it can amplify gains or losses depending on your position.
Example: Suppose stock ABC is trading at $100, and the implied volatility of an option contract on ABC is 25%. This IV reflects the market’s expectation of how much the stock price might fluctuate over the next year. To understand what this means, we calculate the expected price range for a one standard deviation move. Since 25% of $100 is $25, the market is saying there’s a 68% chance (one standard deviation in a normal distribution) that ABC’s price will be between $75 and $125 one year from now ($100 ± $25).
This also implies there’s a 32% chance the stock will fall outside this range. Half of that 32% (16%) represents the probability that ABC will be above $125, and the other half (16%) is the chance it will be below $75. These probabilities are crucial for options traders. For instance, if you’re considering buying a $130 call option, you know there’s only a 16% chance the stock will exceed $125, making it a riskier bet. Alternatively, selling a $75 put option might seem safer, as there’s an 84% chance (100% - 16%) the stock stays above $75. Understanding this expected range helps traders pick the right options strategies, like buying calls or puts when IV is low or selling spreads when IV is high, to align with their risk tolerance and market outlook.
