Making the most of volatility in these uncertain times

Mar 26 13:03 2020 Print This Article

In our last article we discussed how to reduce the risk associated with the time-value decay of options in a directional position. Now we will take advantage of the market meltdown to discuss the implied volatility in the price of an option, how it reflects the degree of market uncertainty over future price movements in the underlying security, and how to make the most of this phenomenon.

Volatility

What is volatility? Generally speaking, the volatility of a stock is the tendency of its price to rise or fall. The more that a stock price fluctuates, the higher its volatility. Volatility is therefore a measure of the risk associated with changes in the returns on a particular stock, or on the market in general. So the more volatile a stock, the riskier it is.

There are two types of volatility: historical volatility and implied volatility. Historical volatility is measured using historical prices, while implied volatility is calculated using the price of an option. As a result, historical volatility reflects past risk, and does not necessarily predict future risk. However, since volatility is a variable in option pricing models, we can take a given option price and use it to derive the amount of volatility that needs to be entered into the model to obtain that price. This implied volatility therefore reflects market expectations of future changes in returns on the price of the underlying share. The higher the implied volatility, the more the market anticipates large fluctuations in future returns on the underlying stock, and vice versa.

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About Article Author

Option Matters

OptionMatters.ca is a blog about the Canadian options market. OptionMatters focuses on sharing information and insights concerning the use of options in various market conditions. OptionMatters is part of the educational mandate of the Montréal Exchange to assist Canadian's in perfecting their risk management skills.

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