OPTIONS
Ride The Tide Of Volatility
The Third Dimension
Of Option Trading
by 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.
