1. Orange County Investools Users Group
OC Traders 02/28/09
Orange County
Investools Users Group

2. after the Options Industry Council’s Workshop on Volatility

3. Volatility Reflects Price Changes
Volatility reflects fluctuations in the price
Not necessarily an uptrend
Not necessarily a downtrend
Greater fluctuations = greater volatility
02/28/09
Rowena St.Moritz

4. Volatility Two Types of Volatility Historical Volatility
Implied Volatility
02/28/09
Rowena St.Moritz

5. Historical Volatility

6. Historical Volatility
Past volatility, usually annual
An observed fact, not a prediction
Is no guarantee of future volatility
Usually based on daily closing prices
02/28/09
Rowena St.Moritz

7. Historical Volatility
Annualized Standard Deviation (SD) of daily price changes, expressed in percent
The percent amount is relative change, up or down, from the average price
Stocks, options, indexes and sectors have historical volatility
02/28/09
Rowena St.Moritz

8. Historical Volatility
Annualized Standard Deviation (SD) of daily price changes, expressed in percent
Prices within 1 SD ~ 68% of the time
Prices within 2 SDs ~ 95% of the time
Prices within 3 SDs ~ 99% of the time
02/28/09
Rowena St.Moritz

9. Historical Volatility
Illustration
If a stock has an average closing price of $100 and 25% historical volatility, then statistically
~ 68% of the time (1 SD)
Price was within + or - $25 ($75 to $125)
~ 95% of the time (2 SDs)
Price was within + or - $50 ($50 to $150)
~ 99% of the time (3 SDs)
Price was within + or - $75 ($25 to $175)
02/28/09
Rowena St.Moritz

10. Historical Volatility
Available at
Enter the equity symbol
Click on “Historical Volatility”
02/28/09
Rowena St.Moritz

11. Historical Volatility
Example
Example for IWM on 2/22/09
02/28/09
Rowena St.Moritz

12. Historical Volatility
Indexes, Sectors, Stocks, and Options have it
Some sectors may have lower or higher volatility levels, but…
Volatility often changes, even when spread across sectors or indexes
Volatility of stocks within sectors may vary
02/28/09
Rowena St.Moritz

13. Implied Volatility

14. Implied Volatility
Implied volatility is what people often mean when they just say “volatility”
It is expected volatility, a guess
It is a subjective prediction
It is an assumption about a stock’s volatility up to the option’s expiration
02/28/09
Rowena St.Moritz

15. Implied Volatility
By definition, it implies a stock’s future volatility, but…
Implied volatility is a feature
only of options
02/28/09
Rowena St.Moritz

16. Implied Volatility Only Options Have It
Stocks do not have implied volatility
Stocks have historic volatility only
Options do have implied volatility
Calls have implied volatility
Puts have implied volatility
02/28/09
Rowena St.Moritz

17. Implied Volatility Can be at great variance with historical volatility
Is not necessarily right or wrong
May change abruptly and significantly
An option’s implied volatility can change without a change in the underlying stock’s price
02/28/09
Rowena St.Moritz

18. Implied Volatility Predicts a range of future possible stock prices
Higher volatility = greater range of possible stock prices
Lower volatility = smaller range of possible stock prices
02/28/09
Rowena St.Moritz

19. Implied Volatility Example Example for IWM on 2/22/09
02/28/09
Rowena St.Moritz

20. Implied Volatility Index Options’ Implied Volatility Symbols
S&P day implied volatility VIX
VIX is what people usually mean by “the” volatility index
Dow Jones Industrial Avg 30-day implied volatility VXD
Nasdaq day implied volatility VXN
Russell day implied volatility RVX
02/28/09
Rowena St.Moritz

21. Implied Volatility Index Options’ Implied Volatility 02/28/09
Rowena St.Moritz

22. Implied Volatility S&P 500 30-day implied volatility VIX 02/28/09
Rowena St.Moritz

23. Implied Volatility Dow Jones 30-day implied volatility VXD 02/28/09
Rowena St.Moritz

24. Implied Volatility Nasdaq 100 30-day implied volatility VXN 02/28/09
Rowena St.Moritz

25. Implied Volatility Russell 2000 30-day implied volatility RVX 02/28/09
Rowena St.Moritz

26. Implied Volatility Things that affect implied volatility
General stock market psychology
Economic data, Federal Reserve actions, and other news
Change in the implied volatility of other option classes within the same industry sector
Market activity (volume)
02/28/09
Rowena St.Moritz

27. Implied Volatility Things that increase implied volatility
Rising volume
Drop in price
Bad news
Nearing an announcement (e.g. earnings)
02/28/09
Rowena St.Moritz

28. Implied Volatility Things that decrease implied volatility
Declining volume
Rise in price
Good news
After an announcement (e.g. earnings)
02/28/09
Rowena St.Moritz

29. Price and Implied Volatility

30. Price and Implied Volatility
An Option’s price
has two components
Intrinsic value
Time value
02/28/09
Rowena St.Moritz

31. Price and Implied Volatility
Option’s Time Value
Time until expiration (known)
Cost of money (known or predictable)
Interest
Dividends
Volatility (unpredictable)
As the cost of money approaches zero, volatility is a greater portion of time value
02/28/09
Rowena St.Moritz

32. Price and Implied Volatility
Implied Volatility = Risk
Implied Volatility affects option premium
Higher volatility means higher option premium
Lower volatility means lower option premium
02/28/09
Rowena St.Moritz

33. Price and Implied Volatility
Higher volatility
Sellers want more for their increased risk
Buyers pay more
Lower volatility
Sellers take less for their decreased risk
Buyers pay less
02/28/09
Rowena St.Moritz

34. Price and Implied Volatility
As stock volatility increases, the price of calls and puts generally increases
As stock volatility decreases, the price of calls and puts generally decreases
02/28/09
Rowena St.Moritz

35. Price and Implied Volatility
If you are long a call or a put, then you want the option’s implied volatility to increase so that the option’s price will go up
If you are short a call or a put, then you want the option’s implied volatility to decrease so that the option’s price will go down
02/28/09
Rowena St.Moritz

36. Price and Implied Volatility
Implied Volatility’s Effect on Options
Greatest nominal (dollar) effect on ATM Calls and Puts (because they have the greatest time value)
Greatest percentage effect on OTM Calls and Puts
Least effect on ITM Calls and Puts because they have so little time value
02/28/09
Rowena St.Moritz

37. Vega and Implied Volatility

38. Vega and Implied Volatility
Vega is “one of the Greeks”
Vega is theoretical - in reality, price changes may differ from those predicted by Vega
Vega’s value decreases with time
Stock has zero Vega
02/28/09
Rowena St.Moritz

39. Vega and Implied Volatility
Vega is expressed in dollars/cents
Shows expected option price change for a
1%-point change in implied volatility
Can be expressed per option or per contract
Spreads and other complex positions have a net vega (positive for long positions and negative for short positions)
02/28/09
Rowena St.Moritz

40. Vega and Implied Volatility
Illustration of Implied Volatility’s relationship to Vega
$80 Call is $3.50 ($350 per contract)
Implied Volatility is 35% and Vega is $.15
If underlying equity’s price remains unchanged
If Implied Volatility rises 1 point, the contract price is expected to rise $15 to $365
If Implied Volatility falls 1 point, the contract price is expected to fall $15 to $335
02/28/09
Rowena St.Moritz

41. Vega and Implied Volatility
Example for IWM on 2/22/09 at ThinkOrSwim
02/28/09
Rowena St.Moritz

42. Vega and Implied Volatility
Explanation of Example for IWM on 2/22/09 at ToS
$40 IWM March Put is $1.815
Implied Volatility is 52.35%
Vega is 4.31 per contract or $.0431 for the option
If IWM’s price is unchanged and Implied Volatility
Rises 1 pt, contract price is expected to rise to $185.81
Falls 1 pt, contract price is expected to fall to $177.19
02/28/09
Rowena St.Moritz

43. Vega and Implied Volatility
Vega’s Bell Curve
Vega is greatest on ATM Calls and ATM Puts (because they have the greatest time value)
Vega is smaller on OTM Calls and OTM Puts
Vega is smallest on ITM Calls and ITM Puts
02/28/09
Rowena St.Moritz

44. Conclusions

45. Conclusions Buy Low and Sell High
Refers to volatility as well as price
Sell options during high volatility
Buy options during low volatility
02/28/09
Rowena St.Moritz

46. Conclusions Buy Low Volatility and Sell High Volatility
If earnings are coming out and the stock’s volatility is up
You believe that the stock’s price will skyrocket after the earnings announcement
You want to buy a Call to profit from the price increase
Consider selling a Put, instead of buying a Call
You can buy back the Put right after volatility drops
Even if the stock’s price doesn’t rise, you may profit from decreased volatility – you can be wrong and still profit
02/28/09
Rowena St.Moritz

47. Conclusions Thinkorswim’s recommendations on volatility
When volatility is low and rising
Purchase Calendar Spreads
Purchase Double Diagonal Spreads
When volatility is high and falling
Sell Iron Condors
Sell Vertical Spreads
02/28/09
Rowena St.Moritz

48. The End