How Volatility Affects Options Trading

There are three variables that are usually basic considerations that are taken into account during successful trading of options. One variable is the expected price direction, another is the timing of the expected move, and the third is the future volatility of the underlying stock. Of these three, volatility is the variable that is most often misunderstood, or in some cases, completely ignored.

Volatility can be defined as the annualized standard deviation of daily returns. There is a much simpler definition, however, which defines volatility as the fluctuation of the price of any given stock without regard to the direction of that fluctuation. A stock that has a price that varies over time by a wide margin is said to be highly volatile, while a stock that has a price that experiences minimal degrees of fluctuation is said to have low volatility.

In order to successfully predict the future volatility of a stock it is imperative to gain an understanding of how volatility affects the price of an option. We can gain this understanding by comparing how an option is priced to how an insurance contract is priced. By paying a premium to another party to assume the risk, a person can purchase an option contract to protect their cash or stock position against market fluctuations in the same way that an insurance policy owner transfers the risk of owning real property to another party for a fee. Options are instruments that transfer risk. They were created by the need investors had for their investments to be protected against dangerous price fluctuations in agricultural markets. Please consider a couple of examples.

By purchasing equity puts share for share with owned stock, an investor acquires the right to sell the underlying stock for a certain length of time at a specific fixed price. The right to sell protects the owner against a decline in the stocks price until the expiration of the option. If an investor buys equity calls, an investor has the right to buy the underlying stock for a certain period of time at a specific price. This right to buy insures the owner's cash position against a price increase in the underlying stock until the expiration of the option. Both types of options protect the investor from unfavorable events with the put protecting against "real loss", and the call protecting against "opportunity loss" in exactly the same way as insurance policies.

An insurance company determines the price of an insurance policy through the consideration of potential risk. They hire actuaries to evaluate the risk potential involved in writing their policies. Hurricane forecasts, theft statistics, and health care factors are all issues of risk that are taken into consideration when actuaries determine the price of an insurance policy. In the options marketplace where risk comes from the possible price fluctuations of an underlying stock, market makers price options based on the forecast of a stock's future volatility.

As an example, suppose that a company is expected to announce its earnings. Now suppose that when the announcement comes there is a big difference between the announced earnings and the expectations that were forecast by analysts. This common situation often times causes the price of a stock to fluctuate dramatically. In this instant, a Markey maker might offset the potential risk of volatility by inflating the option premium. By the same token, if uncertainty about the price of a stock is actually reduced after the announcement of the earnings, a market maker could very well justify lowering the option premium in light of its perceived low risk, and hence, low volatility.