Options and the concept of volatility are heavily intertwined thanks to underlying asset price relations. Volatility is easy to define: The amount of changes in an asset’s price and the rate changes occur in a period of time. The volatility of the underlying asset and the value of the option are interrelated.
Remember that an option’s strike price has to be exceeded by its market price to be exercised. This means above the strike price if a call or below the strike price if a put. An underlying asset with frequent wide price swings is more likely to move past the strike price than a calmer underlying asset. Underlying assets that have high price volatility are, all else equal, more desirable for option holders. Options with underlying assets that have lower volatility are more desirable for writers. This is especially true with American Style options which can be exercised at any point, as long as the option is in the money.
Higher volatility has higher chances to be exercised, and it is not forgotten when paying premiums. You will pay high premiums on options that have higher underlying asset volatility. This offsets the risk of the writer being more likely to encounter financial losses due to price swings. There are two volatility measurements: historical volatility and implied volatility.
Implied Volatility (IV) estimates an underlying asset’s lifelong volatility levels, and is derived from changes in price. As the option trades, IV estimates the option’s lifelong volatility based on multiple factors, including market conditions. Volatility is displayed as an annualized number. Implied volatility looks ahead, while historical volatility is a record of what’s behind. IV is derived from price changes, which are altered by market behaviors, which in turn are altered by rumors, expectations, and events. Implied Volatility is higher when the market is on a downswing, and lowers when the market is in an upswing. If volatility increases, prices of options also typically increase. If implied volatility decreases, prices of options also typically decrease. All of these assumptions require that other variables are held equal.
The differences between historical volatility and implied volatility are an indicator of potential option mispricings. If the option’s historical volatility and implied volatility have a large distance between them, the price of the option may not be in line with the underlying asset. This can reveal a miss pricing opportunity to attentive investors, especially if a trend is widening.
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