39 lines
3.1 KiB
Plaintext
39 lines
3.1 KiB
Plaintext
Chapter 36: The Basics of Volatility Trading 733
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At any one point in time, a trader knows for certain the following items that
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affect an option's price: stock price, strike price, time to expiration, interest rate, and
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dividends. The only remaining factor is volatility - in fact, implied volatility. It is the
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big "fudge factor" in option trading. If implied volatility is too high, options will be
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overpriced. That is, they will be relatively expensive. On the other hand, if implied
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volatility is too low, options will be cheap or underpriced. The terms "overpriced" and
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"underpriced" are not really used by theoretical option traders much anymore,
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because their usage implies that one knows what the option should be worth. In the
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modem vernacular, one would say that the options are trading with a "high implied
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volatility" or a "low implied volatility," meaning that one has some sense of where
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implied volatility has been in the past, and the current measure is thus high or low in
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comparison.
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Essentially, implied volatility is the option market's guess at the forthcoming sta
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tistical volatility of the underlying over the life of the option in question. If traders
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believe that the underlying will be volatile over the life of the option, then they will
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bid up the option, making it more highly priced. Conversely, if traders envision a non
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volatile period for the stock, they will not pay up for the option, preferring to bid
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lower; hence the option will be relatively low-priced. The important thing to note is
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that traders normally do not know the future. They have no way of knowing, for sure,
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how volatile the underlying is going to be during the life of the option.
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Having said that, it would be unrealistic to assume that inside information does
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not leak into the marketplace. That is, if certain people possess nonpublic knowledge
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about a company's earnings, new product announcement, takeover bid, and so on,
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they will aggressively buy or bid for the options and that will increase implied volatil
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ity. So, in certain cases, when one sees that implied volatility has shot up quickly, it is
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perhaps a signal that some traders do indeed know the future - at least with respect
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to a specific corporate announcement that is about to be made.
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However, most of the time there is not anyone trading with inside information.
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Yet, every option trader - market-maker and public alike - is forced to make a
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"guess" about volatility when he buys or sells an option. That is true because the price
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he pays is heavily influenced by his volatility estimate ( whether or not he realizes that
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he is, in fact, making such a volatility estimate). As you might imagine, most traders
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have no idea what volatility is going to be during the life of the option. They just pay
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prices that seem to make sense, perhaps based on historic volatility. Consequently,
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today's implied volatility may bear no resemblance to the actual statistical volatility
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that later unfolds during the life of the option.
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For those who desire a more mathematical definition of implied volatility, con
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sider this. |