FFO Options 6: Volatility and Profitability

Dr. Scott BrownStock Options

IntroductionAlong with time, volatility is what gives an option its

extrinsic value. The higher the volatility of a stock, the higher the option’s price.

If you own a call option, you’re not as concerned with the downside risk as you are when holding a stock. If you own the stock, you can make dollar-for-dollar on the upside but you also lose dollar-for-dollar on the downside.

What determines the value of the call or put is the likelihood that stock will make large share price moves.

Introduction (Cont.)Volatility is typically measured in percents; the bigger the

percentage, the more volatile the stock.

A high-volatility stock is one that exhibits large price swings throughout the day or over time. Low-volatility stocks are those whose prices do not move too much.

It’s important to remember that high volatility does not necessarily mean better performance. A stock can be very volatile yet moving in the wrong direction; up for a put; or down for a call!

A Simple Pricing ModelThe size of the jumps – volatility – in a stock’s price is the

key to determining what an option is worth.

Ex: Assume stock a is trading at $50 and can rise or fall by $5 at expiration with equal probability.There are only two final possible prices, $45 and $55

Now, if you would pay $5 for the $50 call, then half the time you would break even and half the time you’d lose $5. Nobody in the market pays $5 because it’s too much to pay.

$2.50 is the price you should be willing to pay. This is called fair value.

A Simple Pricing Model Fair value of an option is the price at which you neither gain nor lose

over the long run.

It’s important to understand that with the fair value of an option, we’re talking about the price where you would break even if you where allowed to play this exact option hundreds and hundreds of times.

Another way of figuring out the fair value mathematically is by multiplying each probability by the payout and then adding them together.Ex: If half the time the option is worth $5 and half the time it is worth zero;(0.50 * $5) + (0.50 * 0) = + $2.50

This is called ms the expected value and shows what the call option is expected to be worth in the long run.

Fair Value: How Much Is A Bet Worth?The value of any bet is determined by two things: 1) The

reward and 2) The probability of winning the reward.

As probability of winning increases (and thus the reward), so does the value of the bet.

The first step in determining what we should pay for any bet is to determine the probability of winning.

As a reminder, just because the bet is fair doesn’t mean you cannot end up on the winning or losing side. The fair price for both just means that, over the long run, neither side is expected to end up on the winning or losing side.

Fair Vale Depends on Perspective The fair value of any bet depends on our perspective; it depends on our

views of the probability of winning.

As gamblers, it’s up to us to decide which viewpoint is more realistic. Should we assume the chances of winning are 50%? Or is 60% a better assessment? Notice that if we assume 50% is a better guess we will be outbid by another gambler if he feels 60% is a more realistic probability. The other gambler will bid more for the bet he perceives to be worth mor.

Whether we should use 50% or 60% (or something else) to value this coin flip is an important question. It’s even more important when valuing options. However, few option traders ever check to see how the price of an option compares to their assessment of value. Failure to do so is the leading reason that option traders lose with options.

The Black-Scholes Option Pricing ModelNamed after Fischer Black and Myron Scholes.

There are six factors used to determine the price of a call and a put option:• Stock Price• Exercise Price• Risk – Free Interest Rate• Time to Expiration• Dividends• Volatility

The Black-Scholes Option Pricing Model (Cont.) Volatility is the most important factor for the fact that it’s the only

true unknown factor. If the price of an option is unknown the historical volatility

helps the Black-Scholes model calculate a fair price.

But in most option the market price of an option is known through the normal auction process between the bid and the ask.

The Black – Scholes Model looks at volatility in a special way when the price of the option is known because it is trading in the market. In this case the Black-Scholes estimates what traders believe that the future volatility of the stock. This is called implied volatility.

It’s the option seller’s forecasts of future volatility of the stock that determines the price of an option.

Why You Need to Understand Volatility If you don’t understand the role of implied volatility, you

can end up with unpleasant surprises.

Many option traders believe option trading is a relatively easy task and that you buy calls when you think the stock is going up and buy puts when you think it’s going to fall. After all, that’s all that’s needed to trade stocks.

When most traders make the switch to options, they apply this same directional procedure to the options market. However, this approach ignores the time value of calls and puts in terms of implied volatility, and paradoxically losses can occur.

Direction Versus SpeedOption traders must not only guess the direction of the stock

correctly but they must also guess how quickly the stock’s price will get there – the speed.

If you think a stock is moving higher, you can’t just buy a call in place of the stock and expect to make money if you are correct.

For an out of the money put or call with long term expiration like an out-of-the-money LEAP the time premium of the option is very high and expensive. The breakeven price is pushed too high and the option often lose money even though the underlying stock moves favorably; up for a call; down for a put.

Direction Versus SpeedTraders must learn to properly price the extrinsic value of

an option.

If they overpay for extrinsic value, they more frequently end up with a loss even if their directional forecast is correct.

Warren Buffet said it beautifully about getting this right: “Price is what you pay. Value is what you get.”

Option Prices and Point SpreadsThe spread acts as a way to even up the bet. It’s a way in

which markets are created.

The spread is increases until there are an equal number of buyers at the bid and sellers at the ask. The spread is calibrated there are an equal number of buyers and sellers on each side of the bet at the bid and at the ask.

Option pricing models like the Black-Scholes allow traders to determine whether a price of an option reflects the fair value based on historic volatility.

Volatility Moves Sideways VIX = Volatility Index See http://finance.yahoo.com

The VIX measures the volatility in the S&P 500 Index.

The sideways characteristic of volatility is about the only constant in options trading and that’s why it’s so important to understand. When volatility rises, there is a tendency for it to fall and vice versa. This shows that there is some long-term average that the volatility oscillates around.

The tendency for volatility to fall toward the long-term average is called mean reversion. Volatility tends to revert to the mean.

“Any time that an extreme event happens, whether good or bad, chances are that following events will be less extreme, not more.”

The VIX tends to move back and forth. When it moves significantly outside of this range, we should expect it to revert back to the average rather than to continue to rise or fall.

Volatility Moves Sideways

Using VolatilityBefore we buy any option, we need to check the past (historic)

volatility of the underlying stock.

You can find this information for free at www.ivolatility.com

It is important to understand how to interpret a chart showing the historic volatility of a stock.

The computer takes the first 30 days, calculates the historic volatility number, and then plots that number as a single point on the chart. Next, it takes days 2 through 31, finds the historic volatility number, and then plots that number as a single point on the chart. This process continues for all 30 – day groups in the data. When it’s done, all the dots are connected and you’re left with a fluctuating line.

Using Volatility What actual future (soon to be historic) volatility can you expect

during the next 30 days? Many traders use the current historic volatility level based on a simple theory the next 30 days should be about like the last 30 days.

Many traders incorrectly believe that any time you find an option whose value is less today than it was previously must be due only to time decay.

You must remember that there are three forces acting on an option’s price at all times – the stock price, time decay, and volatility.

Time decay means that time has been subtracted from the life of the option and therefore the option must be worth less money, all else the same.

Creating a Winning Trade Just because you’re bullish doesn’t mean buying calls is the

right strategy to capitalize on that outlook. Tong option positions have a “point-spread” built into them in the form of a time premium. If the premium is too high, we can lose on the option even though the stock price may rise.

In order to trade options successfully, you have to remember that there are two-dimensional assets. If your only opinion is that you’re bullish on the stock, you may be better off buying the stock since it is a one-dimensional asset. But if you want to use options, having an option on the direction of the stock is certainly part of the puzzle but we also need to have an opinion on the historic volatility level in the future.

Creating a Winning Trade (Cont.) In order to make a successful trade, we must pick a strategy that

properly aligns both beliefs – direction and volatility. Always remember that options are two-dimensional assets and we must be right on both counts.

Our beliefs are: Direction = Bullish on the stock Volatility = Option volatility

• To trade options successfully, you must take direction and volatility in to account.

• If you wish to trade on a directional outlook only then use 0.80 to 0.85 deltas.

How Option Prices are Affected by the Model FactorsThe Black – Scholes Model assumes we can fully determine

the fair value of an option just by knowing the six factors that go into the model.Scenario If factor INCREASES Call Price Put Price

1 Stock Price + —2 Exercise Price — +3 Risk Free Rates + —4 Volatility + +5 Time To Expiration + +6 Dividends — +

Dividends If stock pays a dividend, the price of the stock is reduced

by the amount of the dividend for the next trading session. The reason the price is reduced is because the company has paid out cash – one of its assets – so the company is now worth less than before it paid the dividend.

Key ConceptsVolatility can be considered a measure of how far a stock

price typically drifts from its average.Volatility is a key component to an option’s price. Implied volatility is the only unknown variable when the

option’s price is known.The fair value of an option is the price at which you would

break even over the long run if you were to buy (sell) it many, many times at that price.

The price of an option is in no way related to its value. Very “cheap” options can be grossly overpriced and very “expensive” options can be a steal. It all depends on volatility.

Volatility moves sideways over time. To trade options successfully, you must take direction and

volatility into account. If you wish to trade an option based on a directional outlook then use 0.80 to 0.85 deltas.

Disclaimer DISCLAIMER: THE DATA CONTAINED HEREIN IS BELIEVED TO BE RELIABLE BUT CANNOT BE

GUARANTEED AS TO RELIABILITY, ACCURACY, OR COMPLETENESS; AND, AS SUCH ARE SUBJECT TO CHANGE WITHOUT NOTICE. WE WILL NOT BE RESPONSIBLE FOR ANYTHING, WHICH MAY RESULT FROM RELIANCE ON THIS DATA OR THE OPINIONS EXPRESSED HERE IN. DISCLOSURE OF RISK: THE RISK OF LOSS IN TRADING FUTURES, FOREX AND OPTIONS CAN BE SUBSTANTIAL; THEREFORE, ONLY GENUINE RISK FUNDS SHOULD BE USED. FUTURES, FOREX AND OPTIONS MAY NOT BE SUITABLE INVESTMENTS FOR ALL INDIVIDUALS, AND INDIVIDUALS SHOULD CAREFULLY CONSIDER THEIR FINANCIAL CONDITION IN DECIDING WHETHER TO TRADE. OPTION TRADERS SHOULD BE AWARE THAT THE EXERCISE OF A LONG OPTION WOULD RESULT IN A FUTURES OR FOREX POSITION.HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL, OR IS LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. PS.  In our opinion, we believe, it may be possible, that heavy smoking and drinking may be hazardous to your health.  If you choose to smoke and drink while trading, The Delano Max Wealth Institute nor Dr. Scott Brown is liable for any damage it may cause.  If you slip and fall on the ice, we're not liable for that either.