Implied Volatility and

Profit vs. Loss

1-888-OPTIONS
www.OptionsEducation.org
Viewing Time: 17 minutes
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Implied Volatility and Profit vs. Loss
Presentation Outline
Volatility review
what is volatility?
kinds of volatility
effects of changing implied volatility on calls and puts
implied volatility and stock price variance
Measuring changes in implied volatility
vega
Implied volatility in the marketplace
implied volatility behavior
implied volatility and your positions
Long and short options: Hypothetical Examples
2 stocks over time
begin and end at
same price
Which stock is more
volatile?
Volatility Review
Volatility represents price fluctuation
of underlying stock over time
no bias for up or down move
quantified as one standard deviation price
change (in %)
Volatility Review
Key factor of pricing model and theoretical values
input for model is an assumption
shorter-term options key unknown
longer-term options key unknown
(+ interest risk)
Increasing volatility
option buyers pay more for more stock fluctuation
option sellers want more for increased risk
Decreasing volatility
buyers pay less for smaller fluctuation
sellers take less for decreased risk
Historical and Expected Volatility
Historical volatility
underlying stock fluctuation observed and
measured
over time usually 1 year
can be recalculated daily will change
a fact, not a prediction
Expected volatility
prediction of future stock price fluctuation
totally subjective your call ultimately
History may or may not repeat itself!
Implied Volatility
Applies to options
volatility assumption at which option is currently priced
may be determined via option pricing model
consensus of marketplace
not necessarily right or wrong
Can be at great variance with historical volatility
may be highly dynamic
may change intraday sometimes significantly
may or may not come in line with historical
may apply to single option series or class of options
Effects of Changing Volatility
Reflects expected variance in stock price
over options lifetime
more variance potentially greater profits for buyers
Volatility assumption (historical, expected, implied)
expressed as standard deviation in % form (e.g. 30%)
annualized
Change in Volatility
(Implied or Assumed)
Call
Prices
Put
Prices
Volatility
Volatility
Volatility as Expected Variance in
Underlying Stock Price
Example:
XYZ currently at $60
volatility assumption 30%
In one years time
XYZ to trade in range between $42 and $78
( 30%)
68% of time (1 standard deviation)
therefore, only 32% outside this range
Bear this in mind
when assessing implied volatility levels
when pricing an option yourself
Measuring Changes
in Implied Volatility
Vega (aka kappa or omega)
Sensitivity of option price to change in volatility
generated by option pricing model
change expected in price for 1%-point (percentage
point) change in implied
expressed in dollars and cents
theoretical in nature
Implied up 1%-point calls/puts up by
vega amount
Implied down 1%-point calls/puts down by
vega amount
Vega Example
XYZ at $60
90 days until expiration
XYZ 3-month 60 call (or put) at $3.70
implied volatility = 30%
vega = 0.118 ( 12)
Implied volatility up to 31%
call (or put) price up to $3.70 + $0.12 = $3.82
Implied volatility down to 29%
call (or put) price down to $3.70 - $0.12 = $3.58
Effect of Vega
Any increase or decrease in option price
due to changing implied volatility is in time
value only
In-the-money options
least time value small dollar and percentage
changes
At-the-money options
most time value largest dollar changes
Out-of-the-money options
all time value largest percentage changes
Implied Volatility
in the Marketplace
See the Future?
Changing volatility not necessarily predictable
May be influenced by (among other things):
news or rumors on underlying stock
world events (political or military)
volatility of broad market
If you expect change in implied volatility levels
degree of change can surprise
timing of change can be swift\
Allow for changing volatility when buying/selling
experience is best guide
Rules of Thumb
Buy low, sell high
when implied is low many investors will buy
when implied is high many investors will sell
be aware of past implied volatility levels to judge
again, your call
Buy rumor, sell fact
public rumors of upcoming news can drive implied up
when news is announced, implied levels often drop
When underlying drops, implied levels increase
Implied Volatility
More than Variance?
Implied volatility is a consensus
all market participants in the mix
some expecting/predicting underlying volatility change
supply and demand also a factor
Supply and demand
more buyers than sellers prices up implied up
more sellers than buyers prices down
implied down
possibly reflects expected up/down trend for stock
not necessarily reflects expected change in
stock volatility
this effect may be short-term, even intraday
Implied Volatility and Your Position
Changes in implied affect time value
can impact profit or loss during positions lifetime
During lifetime, implied volatility increases?
buyers may take earlier profits
sellers may feel pressured to stem losses
During lifetime, implied volatility decreases?
buyers may feel pressured to stem losses
sellers may take earlier profits
At expiration, options have intrinsic value or not
implied volatility is moot at this point
Implied Volatility and Your Position
Option buyers
expect favorable move in underlying
want implied volatility to increase
implied increase may offset time decay
exit plan: should allow for implied to drop
Option sellers
expect favorable move in underlying
want implied volatility to decrease
implied decrease may add to time decay
exit plan: should allow for implied to rise
Implied Volatility and Your Forecast
Include changing implied in your forecast?
If wrong about stock move and right about implied
may not see losses, or
may lose less than you could have
If right about stock move and wrong about implied
may not see profits, or
may see less profits than you could have
Long and Short Options
Hypothetical Examples
Long Call
Buy XYZ 3-month 60 call at $3.70
XYZ at $60 implied volatility 30%
After 1 month XYZ still at $60
implied down to 25% = call at $2.50
implied remains 30% = call at $3.00
implied up to 35% = call at $3.50
Increased
Loss
Decreased
Loss
Long Call
Buy XYZ 3-month 60 call at $3.70
XYZ at $60 implied volatility 30%
After 1 month XYZ up to $65
implied down to 25% = call at $5.90
implied remains 30% = call at $6.30
implied up to 35% = call at $6.70
Decreased
Profit
Increased
Profit
Long Call
Buy XYZ 3-month 60 call at $3.70
XYZ at $60 implied volatility 30%
After 1 month XYZ down to $55
implied down to 25% = call at $0.65
implied remains 30% = call at $1.00
implied up to 35% = call at $1.40
Increased
Loss
Decreased
Loss
Covered Call
Sell XYZ 2-month 65 call at $1.90
XYZ at $62 implied volatility 30%
After 1 month XYZ still at $62
implied down to 25% = call at $0.75
implied remains 30% = call at $1.00
implied up to 35% = call at $1.35
Increased
Profit
Decreased
Profit
Covered Call
Sell XYZ 2-month 65 call at $1.90
XYZ at $62 implied volatility 30%
After 1 month XYZ down to $57
implied down to 25% = call at $0.01
implied remains 30% = call at $0.15
implied up to 35% = call at $0.30
Cover and
Sell Another
Call?
Decreased Profit
on Option
Covered Call
Sell XYZ 2-month 65 call at $1.90
XYZ at $62 implied volatility 30%
After 1 month XYZ up to $67
implied down to 25% = call at $3.10
implied remains 30% = call at $3.50
implied up to 35% = call at $3.85
Decreased Loss
on Option
Increased Loss
on Option
Volatility Plays
Profiting from
Changing Implied Volatility
Increasing Implied Volatility
Buy straddle
XYZ at $60
buy 2-month 60 straddle at $5.80
implied at 30%
After 2 weeks XYZ still at $60
implied down to 25% straddle at $4.25
implied remains 30% straddle at $5.10
implied up to 35% = straddle at $5.90
Profit on
Volatility
Increase
Alone
Increasing Implied Volatility
You might also consider:
Long strangles (versus long straddles)
cheaper to buy less risk
profits may be less bought out-of-the-money options
bigger move needed to profit from underlying price
change if implied fails to increase
For short-term trading
short time spreads
short butterflies
Decreasing Implied Volatility
Sell straddle
XYZ at $55
sell 1-month 55 straddle at $3.80
implied at 30%
After 2 weeks XYZ still at $55
implied down to 25% straddle at $2.30
implied remains 30% straddle at $2.75
implied up to 35% straddle at $3.20
Increased
Profit from
Volatility Drop
Decreasing Implied Volatility
You might also consider:
Short strangles (vs. short straddles)
selling out-of-the-money options
less risk but less profit potential
bigger move needed to lose from underlying price
change if implied fails to decrease
Long time spreads
Long butterflies and condors
Conclusion
Conclusion
Understand ramifications of implied volatility
vega
implications for underlying price variance
Be familiar with implied volatility behavior
factors that can affect it
When establishing a position
know current implied level compared to past levels
account for favorable or unfavorable implied changes
Expect the unexpected
implied levels can change abruptly and significantly
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