Papale on the Basics: Implied Volatility

I usually start off these blogs with some human interest story.  Something the reader and I can relate to and share.  Today however I ‘m simply going to make a statement of fact.  I’m cold.  It’s 0 outside.  I’m ready for spring.  Maybe a relocation to Hawaii.  That is all.

This week we will continue our discussion on calls and puts by going over what factors drive the price of options in a bit more detail.  There are basically two things that affect the price of options –  movement of the underlying and implied volatility.  There are some others but these are the main two so we will stick with these today.  As we discussed last week, as prices of an underlying go up, calls tend to rise and puts tend to fall.  This is simply due to the relative value of the option compared to the level of  underlying.  Obviously if I am long puts, which give me the right to sell the underlying at a predetermined price, if the underlying falls the value of my puts, all else being equal, should go up.  The opposite goes for calls.  If I own IBM 200 calls and the stock rallies like crazy, my calls will tend to rise as I am guaranteed to buy IBM at $200 no matter how high the stock goes.

In reality however, the options don’t always move the way we might expect.  Stocks rally and sometimes calls barely move.  Much of this can be attributed to what we call Implied Volatility.  Implied Volatility is the option’s value attributed to the market’s perception of how volatile or how much perceived risk there is in the underlying in the future.  For example, say IBM is trading at $200.  The Mar 200 calls are trading at $3.  Now let’s pretend there is talk IBM might be getting ready to launch a new product that could either do really well or fall on its face.  The price is not moving much.  The options however are rising.  The calls that were trading $3 are now trading at $4.  Stock has not moved.  This rise in options price is due entirely to rising implied volatility.  Greater uncertainty generally means higher options prices.  Remember options are essentially insurance policies.  And what happens when that uncertainty goes down?  Implied volatility generally falls.  In the IBM scenario, IBM comes out and says there is no product launch planned.  It was only a rumor.  Calls will likely go back toward $3.  Again, stock has not moved.  Same thing happens with puts.  As a rule all options, both calls and puts move up with rising implied volatility ignoring the effect of price movement in the underlying.  So next time you buy those calls and the stock goes up but the calls barely move it’s likely due to the fall in implied volatility in the calls.  That affect is pushing against the force of the rising underlying to push calls up.  The tug of war between the two will determine the price of the option.

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