1. Implied Volatility and Profit vs. Loss
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Viewing Time: 17 minutes

2. Implied Volatility and Profit vs. Loss
Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained by contacting your broker or The Options Industry Council at One North Wacker Drive, Chicago, IL
In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences.
Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results.
Before we begin, I would like to make the following points. First, I am not a licensed broker or a registered investment advisor, so everything I say tonight is for educational purposes only. Nothing I say should be considered investment advice.
Second, the examples in the presentation do not include transactions costs, but they are important to consider in real life strategies.
Finally, the options disclosure document “Characteristics and Risks of Standardized Options” is included in you packet of materials. Please read this thoroughly before engaging in any options transactions.
Questions? Now let’s get into the presentation

3. 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
Here is an outline of what I will discuss this evening.
After a very brief review of the basics, we will focus specifically on spread strategies. This is not a basic-level seminar, so if you have never traded options, then some of this may be too complicated. The Options Investigator is the software disk included in your materials, and can be a useful tool to analyze option prices and option strategies.
Please feel free to raise your hand and to ask questions at any time. My goal is to make sure you get what you need to feel good about coming here tonight.

4. 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 %)
2 stocks over time
begin and end at same price
Which stock is more volatile?

5. 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

6. 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!

7. 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

8. Effects of Changing Volatility
Change in Volatility
(Implied or Assumed)
Call
Prices
Put
Volatility ↑ ↑
Volatility ↓ ↓
Reflects expected variance in stock price
over option’s lifetime
more variance – potentially greater profits for buyers
Volatility assumption (historical, expected, implied)
expressed as standard deviation in % form (e.g. 30%)
annualized

9. Volatility as Expected Variance in Underlying Stock Price
Example:
XYZ currently at $60
volatility assumption 30%
In one year’s 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

10. Measuring Changes in Implied Volatility
Good evening. My name is ___________________, and am a ________ with the _______________ exchange. Tonight, I represent The Options Industry Council, which is a consortium of six options exchanges and The Options Clearing Corporation that have combined efforts to bring you this series of educational seminars. OIC is now 12 years old, and we have spoken to over 500,000 people.
Can you please tell me a little about who you are and your investment experience. Please raise your hand if you have any experience trading options. Thank you. And how many of you make more than 5 trades per month. And how many of you have traded spreads? Thank you, that gives me some idea.
This evening I plan to talk until 7:20-7:25 and then we will take a 15 minute break. After the break I will talk until about 9:00.
There is a seminar evaluation form, which can be found in the front of your manual. Please take a moment at the end of the seminar to fill out the evaluation.

11. 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

12. Vega Example XYZ at $60 XYZ 3-month 60 call (or put) at $3.70
90 days until expiration
XYZ 3-month 60 call (or put) at $3.70
implied volatility = 30%
vega = (≈ 12¢)
Implied volatility up to 31%
call (or put) price up to $ $0.12 = $3.82
Implied volatility down to 29%
call (or put) price down to $ $0.12 = $3.58

13. 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

14. Implied Volatility in the Marketplace

15. 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

16. Rules of Thumb Buy low, sell high Buy rumor, sell fact
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

17. 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

18. Implied Volatility and Your Position
Changes in implied affect time value
can impact profit or loss during position’s 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

19. 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
want implied volatility to decrease
implied decrease may add to time decay
exit plan: should allow for implied to rise

20. 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

21. Hypothetical Examples
Long and Short Options
Hypothetical Examples

22. 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

23. 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

24. 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

25. 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

26. 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 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
Changed verb from increased to reduced loss

27. Decreased Loss on Option Increased Loss 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
Cahnged for Increased Profit to Increased Loss

28. Profiting from Changing Implied Volatility
Volatility Plays
Profiting from
Changing Implied Volatility

29. 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

30. 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

31. 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

32. 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

33. Conclusion

34. 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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