Implied Volatility
and
Profit vs. Loss
Presented by
The Options Industry Council
Implied Volatility and Profit vs. Loss
Options involve risks and are not suitable for everyone. Prior to buying or
selling options, an investor must receive a copy of Characteristics and Risks
of Standardized Options. Copies may be obtained by contacting your broker
or The Options Industry Council at One North Wacker Drive, Chicago, IL
60606.
In order to simplify the computations, commissions, fees, margin interest and
taxes have not been included in the examples used in these materials.
These costs will impact the outcome of all stock and options transactions and
must be considered prior to entering into any transactions. Investors should
consult their tax advisor about any potential tax consequences.
Any strategies discussed, including examples using actual securities and
price data, are strictly for illustrative and educational purposes only and are
not to be construed as an endorsement, recommendation, or solicitation to
buy or sell securities. Past performance is not a guarantee of future results.
Presentation Outline
• Volatility
-
review
what is volatility?
kinds of volatility
effects of changing implied volatility on calls and puts
implied volatility and stock price variance
• Measuring
-
Vega
• Implied
-
changes in implied volatility
volatility in the marketplace
implied volatility behavior
Implied volatility and your positions
• Examples
Volatility Review
• Volatility
-
represents price fluctuation
of underlying stock over time
no bias for up or down move
quantified as one standard deviation price change (in %)
2 Stocks over time
begin and end at
same price
More volatile =
Less volatile =
Volatility Review
• Key
factor of pricing model and theoretical
values
-
input for model is an assumption
shorter-term options - key unknown
longer-term options - key unknown (+ interest risk)
• Increasing
-
volatility
option buyers pay more for more stock fluctuation
option sellers want more for increased risk
• Decreasing
-
volatility
buyers pay less for smaller fluctuation
sellers take less for decreased risk
Historical and Expected Volatility
• Historical
-
observed and measured underlying stock fluctuation
over time – usually 1 year
can be recalculated daily – will change
a fact, not a prediction
• Expected
-
volatility
volatility
prediction of future stock price fluctuation
totally subjective – your call ultimately
• History
may or may not repeat itself!
Implied Volatility
• Applies
-
volatility assumption at which option is currently priced
obtained via option pricing model
consensus of marketplace
not necessarily right or wrong
• Can
-
to options
be at great variance with historical volatility
can be highly dynamic
may change intra-day – sometimes significantly
may or may not come “in line” with historical
may apply to single option series or class of options
Effects of Changing Volatility
Change in Volatility
(Implied or Assumed)
Call
Prices
Put
Prices
Volatility ↑
↑
↑
Volatility ↓
↓
↓
• Reflects expected
- over option’s lifetime
-
variance in stock price
more variance – potentially greater profits for buyers
• Volatility
assumption (historical, expected,
implied)
-
expressed as standard deviation in % form (e.g. 25%)
annualized
Volatility as Expected Variance
in Underlying Stock Price
• Example:
-
XYZ currently at $60
volatility assumption 25%
• In
-
one year’s time
XYZ to trade in range between $45 and $75 (±
25%)
≈ 68% of time (1 standard deviation)
therefore, only ≈ 32% outside this range
• Bear
-
this in mind
when assessing implied volatility levels
when pricing an option yourself
Measuring Changes
in
Implied Volatility
Vega (aka kappa or omega)
• Sensitivity
-
of option price to change in volatility
generated by option pricing model
change expected in price for 1% change in implied
expressed in dollars/cents
theoretical in nature
implied up 1% - calls and puts up by vega amount
implied down 1% - calls and puts down by vega
amount
Vega Example
• XYZ
-
90 days til expiration
• XYZ
-
at $60
3-month 60 call (or put) at $3.30
implied volatility = 25%
vega = 0.12 (12¢)
• Implied
-
call (or put) price up to $3.42
• Implied
-
volatility up to 26%
volatility down to 24%
call (or put) price down to $3.18
Effect of Vega
• Any
increase or decrease in option price due
to changing implied volatility is in time value
only
• In-the-money
-
least time value – small dollar and percentage
changes
• At-the-money
-
options
options
most time value – largest dollar changes
• Out-of-the-money
-
options
All time value – largest percentage changes
Implied Volatility
and the
Option Marketplace
See the Future?
• Changing
• May
-
• If
-
volatility not necessarily predictable
be influenced by (among other things):
news or rumors on underlying stock
world events (political or military)
volatility of broad market
you expect change in implied volatility levels
degree of change can surprise
timing of change can be swift
• Allow
for changing volatility when
buying/selling
-
experience is best guide
Rules of Thumb
• Buy
-
low, sell high
when implied is low many investors buy
when implied is high many investors will sell
be aware of past implied volatility levels to judge
again, your call
• “Buy
-
rumor, sell fact”
public rumors of upcoming news can drive implied up
when news is announced implied levels often drop
• When
underlying drops, implied levels increase
Implied Volatility –
More than Variance?
• Implied
-
all market participants in the mix
some expecting/predicting underlying volatility change
supply and demand also a factor
• Supply
-
volatility is a consensus
and demand
more buyers than sellers – prices up – implied up
more sellers than buyers – prices down – implied down
possibly expected up/down trend for stock
not necessarily expecting volatility change for stock
this effect may be short-term, even intra-day
Implied Volatility and Your Position
• Because
-
affects profits or losses during position’s lifetime
• During
-
-
lifetime, implied volatility increases
buyers may take earlier profits
sellers may feel pressured to stem losses
• During
-
changes in implied affect time value
lifetime, implied volatility decreases
buyers may feel pressured to stem losses
sellers may take earlier profits
• At
expiration, options have intrinsic value or not
Implied Volatility and Your Position
• Option
-
expect favorable move in underlying
want implied volatility to increase
implied increase may offset time decay
exit plan: should allow for implied to drop
• Option
-
buyers
sellers
expect favorable move in underlying
want implied volatility to decrease
implied decrease may add to time decay
exit plan: should allow for implied to rise
Implied Volatility and Your Forecast
• Include
changing implied in your
forecast?
• If
wrong about stock move and right about
implied
-
may not see losses, or
may lose less than you could have
• If
right about stock move and wrong about
implied
-
may not see profits, or
may see less profits than you could have
Long and Short Options
Hypothetical Examples
Long Call
• Buy
-
XYZ 3-month 60 call at $3.30
XYZ at $60 – implied volatility 25%
• After
-
1 month – XYZ up to $65
Increased
Loss
implied down to 20% = call at $5.80 ←
implied still at 25% = call at $6.20
implied up to 30% = call at $6.50 ← Profit
Long Call
• Buy
-
XYZ 3-month 60 call at $3.30
XYZ at $60 – implied volatility 25%
• After
-
1 month – XYZ up to $65
Decreased
Profit
implied down to 20% = call at $5.80 ←
implied still at 25% = call at $6.20
Increased
implied up to 30% = call at $6.50 ← Profit
Long Call
• Buy
-
XYZ 3-month 60 call at $3.30
XYZ at $60 – implied volatility 25%
• After
-
1 month – XYZ down to $55
implied down to 20% = call at $0.40 ← Increased
Loss
implied still at 25% = call at $0.75
Decreased
implied up to 30% = call at $1.10 ←
Loss
Covered Call
• Sell
-
XYZ 2-month 65 call at $1.50
XYZ at $62 – implied volatility 25%
• After
-
1 month – XYZ still at $62
Increased
Profit
implied down to 20% = call at $0.45 ←
implied still at 25% = call at $0.75
Decreased
implied up to 30% = call at $1.10 ← Profit
Covered Call
• Sell
-
XYZ 2-month 65 call at $1.50
XYZ at $62 – implied volatility 25%
• After
-
1 month – XYZ down to $57
implied down to 20% = call at $0.02
implied still at 25% = call at $0.10
implied up to 30% = call at $0.15 ←
Cover and
← Sell Another
Call?
Decreased
Loss on
Position
Covered Call
• Sell
-
XYZ 2-month 65 call at $1.50
XYZ at $62 – implied volatility 25%
• After
-
1 month – XYZ up to $67
Increased
Profit on
Position
implied down to 20% = call at $2.90 ←
implied still at 25% = call at $3.20
Decreased
implied up to 30% = call at $3.60 ← Profit on
Position
Volatility Plays
Profiting Simply
from
Changing Implied Volatility
Increasing Implied Volatility
• Buy
-
straddle
XYZ at $60
buy 2-month 60 straddle at $4.90
implied at 25%
• After
-
2 weeks – XYZ still at $60
Volatility
← Loss
Time Decay
implied down to 20% = straddle at $3.45
implied still at 25% = straddle at $4.25 ←
implied up to 30% = straddle at $5.15 ← Profit on
Volatility
Alone
Increasing Implied Volatility
You might also consider:
• Long
-
cheaper to buy – less risk
profits may be less – bought out-of-the-money
options
bigger move needed to profit from underlying price
change if implied fails to increase
• For
-
strangles (vs. long straddles)
short-term trading
short time spreads
short butterflies
Decreasing Implied Volatility
• Sell
-
straddle
XYZ at $55
sell 1-month 55 straddle at $3.20
implied at 25%
• After
-
2 weeks – XYZ still at $55
Increased
implied down to 20% = straddle at $1.80 ← Profit
implied still at 25% = straddle at $2.75 ← Time Decay
implied up to 30% = straddle at $2.70 ← Decreased
Profit
Decreasing Implied Volatility
You might also consider:
•
Short strangles (vs. short straddles)
- Selling out-of-the-money options
- less risk but less profit potential
- bigger move needed to lose from underlying price
change if implied fails to decrease
• Long
time spreads
• Long
butterflies and condors
Conclusion
Conclusion
• Understand
-
vega
implications for underlying price variance
• Be
-
familiar with implied volatility behavior
factors that can affect it
• When
-
establishing a position
know current implied level compared to past levels
account for favorable or unfavorable implied changes
• Expect
-
ramifications of implied volatility
the unexpected
implied levels can change abruptly and significantly
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