44 lines
2.1 KiB
Plaintext
44 lines
2.1 KiB
Plaintext
758 Part VI: Measuring and Trading Volatility
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direct manner. That is, an increase in implied volatility will cause the option price to
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rise, while a decrease in volatility will cause a decline in the option price. That piece
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of information is the most important one of all, for it imparts what an option trader
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needs to know: An explosion in implied volatility is a boon to an option owner, but
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can be a devastating detriment to an option seller, especially a naked option seller.
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A couple of examples might demonstrate more clearly just how powerful the
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effect of implied volatility is, even when there isn't much time remaining in the life
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of an option. One should understand the notion that an increase in implied volatility
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can overcome days, even weeks, of time decay. This first example attempts to quan
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tify that statement somewhat.
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Example: Suppose that XYZ is trading at 100 and one is interested in analyzing a 3-
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month call with striking price of 100. Furthermore, suppose that implied volatility is
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currently at 20%. Given these assumptions, the Black-Scholes model tells us that the
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call would be trading at a price of 4.64.
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Stock Price:
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Strike Price:
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Time Remaining:
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Implied Volatility:
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Theoretical Call Value:
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100
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100
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3 months
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20%
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4.64
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Now, suppose that a month passes. If implied volatility remained the same
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(20% ), the call would lose nearly a point of value due to time decay. However, how
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much would implied volatility have had to increase to completely counteract the
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effect of that time decay? That is, after a month has passed, what implied volatility
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will yield a call price of 4.64? It turns out to be just under 26%.
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Stock Price:
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Strike Price:
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Time Remaining:
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Implied Volatility:
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Theoretical Call Value:
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100
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100
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2 months
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25.9%
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4.64
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What would happen after another month passes? There is, of course, some
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implied volatility at which the call would still be worth 4.64, but is it so high as to be
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unreasonable? Actually, it turns out that if implied volatility increases to about 38%,
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the call will still be worth 4.64, even with only one month of life remaining: |