Educational Programming Video
The Value Line Daily Option Survey
Program 4: Understanding Volatility
In this lesson, we are going to discuss volatility, the prime ingredient of an option's premium.
Just what determines the premium of a call or a put? Well, there are five "known" or easily ascertained variables. These are (1) the stock price, (2) the exercise (or Strike) price, (3) the time until expiration, (4) interest rates and (5) dividend on the stock (if any). In addition, there is one "unknown" or estimated variable - volatility.
Volatility is the expected range within which we expect the stock to end up on its expiration date. It is expressed as a standard deviation. Thus, if we say that a stock has a 25% annual volatility, we mean that one year from now, there is a 68% likelihood that the stock will end up within a range of up or down 25% from today's current price.
Why is volatility important? Remember how in our prior sessions, we stressed that options really are insurance against the risk of making the wrong financial decision. If we knew exactly where a stock was going to end up, there would be no need for this insurance and option time premiums would be exactly equal to zero. The greater a stock's volatility - that is the wider the range of possible outcomes - the greater will be the need for insurance and the higher will be an option's time premium.
Let's look at an example. For an option that is at-the-money (i.e. the stock price equal to the strike price), the option's time premium will always be equal to 40% of the stock's expected standard deviation. Thus for a stock with 25% volatility, the time premium will be 10% of the stock price (i.e. 40% of 25%). If the volatility were 50%, this time premium would be 20%.
Thus, it is easy to tell what the market expects volatility to be. If we know the option premium and the five "known" variables, we can tell how much volatility the market is expecting. We call this volatility derived from premium implied volatility. This implied volatility number always is expressed as an annualized percentage number - just like an interest rate. Because it is standardized, implied volatility is a useful benchmark for comparing different options on different stocks.
You may ask, how does the option market come up with this volatility number? What traders typically do is calculate how volatile a stock has been in the past and try to gauge whether this volatility will continue into the future. This calculation of past volatility is known as historical volatility. It is the annualized standard deviation of past price movements. Usually traders compare the like number of days for their projections. Thus, the historical volatility of a stock over the past 30 days will be heavily weighted in the pricing (i.e., the implied volatility) of an option that expires 30 days hence.
Can you forecast volatility with any accuracy? For years, the Value Line Daily Options Survey has been using its proprietary option volatility-forecasting model to tell whether options are fairly priced with respect to future volatility. Thus, we are able to determine whether an option on a highly ranked stock is reasonably priced and suitable for purchase (as in call buying) or overpriced and suitable for sale (as in covered call writing).
These answers are important ingredient in successful options investing. Over the years, both our call buying and our covered call writing recommendations have strongly outperformed the market on reward/risk basis.
In addition to listing which options should be bought which should be written, we also provide subscribers with the following information on 12,000 options daily: historical volatility; implied volatility; recent premium; and, our estimate of what the premium should be based on our volatility forecast.
In our next session, we are going to tell you what it means to sell or write an option premium.