35 lines
2.5 KiB
Plaintext
35 lines
2.5 KiB
Plaintext
60 • The Intelligent Option Investor
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it is because it is also the definition of the BSM cone. To the extent that
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expectations are not directly observable, forward volatility can only be
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guessed at.
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The option market’s best guess for the forward volatility, as expressed
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through the option prices themselves, is known as implied volatility. We
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will discuss implied volatility in more detail in the next section and will
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see how to build a BSM cone using option market prices and the forward
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volatility they imply in Part III.
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The one other measure of volatility that is sometimes mentioned is sta-
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tistical volatility (a.k.a. historical volatility). This is a purely descriptive statis-
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tic that measures the amount the stock price actually fluctuated in the past.
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Because it is simply a backward-looking statistic, it does not directly affect
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option pricing. Although the effect of statistical volatility on option prices
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is not direct, it can have an indirect effect, thanks to a behavioral bias called
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anchoring. Volatility is a hard concept to understand, let alone a quantity to
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attempt to predict. Rather than attempt to predict what forward volatility
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should be, most market participants simply look at the recent past statistical
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volatility and tack on some cushion to come to what they think is a reason-
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able value for implied volatility. In other words, they mentally anchor on the
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statistical volatility and use that anchor as an aid to decide what forward vola-
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tility should be. The amount of cushion people use to pad statistical volatility
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differs for different types of stocks, but usually we can figure that the market’s
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implied volatility will be about 10 percentage points higher than statistical
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volatility. It is important to realize that this is a completely boneheaded way
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of figuring what forward volatility will be (so don’t emulate it yourself), but
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people do boneheaded things in the financial markets all the time.
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However people come to an idea of what forward volatility is rea-
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sonable for a given option, it is certain that changing perceptions about
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volatility are one of the main drivers of option prices in the market. To
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understand how this works, let’s take a look at what happens to the BSM
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cone as our view of forward volatility changes.
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Changing Volatility Assumptions
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Let’s say that we are analyzing an option that expires in two years, with a
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strike price of $70. Further assume that the market is expecting a forward |