Harnessing Implied Volatility Shifts Is Crucial in Options Trading

By Keith Schap   ISSUE 211 | DEC 2003

Volatility is probably the most important single options pricing factor. Informally, this term refers to how agitated the market is and, in general, serves as an indicator of how risky the option might be. The higher the volatility, the higher the risk, and the higher the option price. In thinking about volatility, it is important to distinguish between historical volatility and implied volatility, although most of what goes into options trade planning involves implied volatility.

Historical volatility values make claims about the history of the futures price and are based on statistical analyses of daily futures price differences for a specified period - 10 days and 30 days are common. This value is then annualized and expressed as a percent. A volatility of five percent claims a 68 percent probability that the futures prices one year forward will fall within a range plus or minus the current price. If the 10-year Treasury note futures price now is 100-00, this five percent volatility says the price in a year is likely to fall somewhere between 95-00 and 105-00. Note that the 68 percent is plus or minus one standard deviation.

Backing into a Definition

Often, you will see option prices quoted in the market that seem at odds with what you think they should be given historical volatility. Suppose that with September 10-year Treasury note futures trading at 116-14 and 40 days to the September option expiration, an option calculator shows that the 116 September put should cost 0-42 (42/64) at a 5.6 percent historical volatility. Yet when you look at an option quote screen, you might see that this option is trading at 0-57. This option price implies a 7.1 percent volatility. To arrive at this price, that is, you would have to use a 7.1 percent volatility, not the 5.6 percent historical volatility reading.

This example underscores that implied volatility is simply the expected volatility that the quoted option price implies and that it is not necessarily equal to historical volatility. The professional traders at the major trading houses estimate what they think the volatility will be between the option transaction date and option expiration. This implied volatility estimate forms the basis for their pricing of the options. When these market professionals consider the situation to be especially risky, the implied volatility will be several points higher than the historical volatility. In this 10-year Treasury note example, the 15/64 price difference represents a risk premium that the traders on the exchange floor take to compensate themselves for making a market in risky circumstances. At other times, these traders may see less risk, and the implied volatility will be lower than the historical volatility.

Isolating the Implied Volatility Factor

A series of what-if exercises can help you begin to appreciate what options traders mean when they say that implied volatility is the most important option-pricing factor. The summer of 2003 was a time of huge volatility shifts in the Treasury markets—especially in the 10-year sector.

On July 16, 2003, 38 days to the September options expiration, September 10-year Treasury note futures settled at 114-23. Two weeks later, on July 30, the September futures settled at 111-30. At-the-money implied volatility was 7.5 percent on July 16 but had climbed to 10.8 percent by July 30.

Had you priced September 113, 112, and 111 put options on 10-year Treasury note futures based on the 114-23 futures price, the 7.5 percent implied volatility, and 38 days to expiration, the option prices would have been those of the Initial Options Prices column in Exhibit 1.

Exhibit 1: An Illustration of the Value of Implied Volatility
7/16/2003			7/30/2003		7/30/2003
September TY Puts			Scenario 1		Scenario 2
Strike Price	Put Price (64ths)	Delta	Put Price (64ths)	Change (64ths)	Put Price (64ths)	Change (64ths)
111	7	0.08	2	-5	11	4
112	15	0.16	7	-8	21	6
113	28	0.26	17	-11	37	9
Dollar equivalents
111	109.375			-78.125		62.500
112	234.375			-125.000		93.750
113	437.500			-171.875		140.625
September TY Puts			Scenario 3		Scenario 4
Strike Price	Put Price (64ths)	Delta	Put Price (64ths)	Change (64ths)	Put Price (64ths)	Change (64ths)
111	7	0.08	30	23	52	45
112	15	0.16	57	42	81	66
113	28	0.26	96	68	118	90
Dollar equivalents
111	109.375			359.375		703.125
112	234.375			656.250		1,031.250
113	437.500			1,062.500		1,406.250

Treasury futures are quoted in points and 32nds. A futures quote of 114-23 indicates a price that is 114 and 23/32 percent of par. The related options are quoted in points and 64ths, so an options quote of 1-32 indicates a price that is 1 and 32/64 percent of par. Exhibit 1 converts the 113 put price in Scenario 3 from 1-32 (or 1’32 on some screens) to 96 (64+32) to make it easier to eyeball the arithmetic. A notation such as 96-28=68 seems more accessible than 1-32 – 0-28 = 1-04.

Based on the November article in this series, you know enough about time decay to know that if the only change was the passage of 14 days, and the futures price and the implied volatility remained the same, these puts would all lose value—a good thing if you’d sold them, bad if you’d bought them. This result is shown in Scenario 1 of Exhibit 1.

But now suppose that, after the passage of 14 days, the futures price stayed the same but the implied volatility soared to 10.8 percent. As the put prices under Scenario 2 show, all of these options would have made a little money. A big enough volatility change can overcome the effect of time decay. Note also that the closer to the money the option strike price (the closer the strike price is to the initial futures price), the greater the effect of a given volatility change.

The option prices under Scenario 3 illustrate the effect of a favorable futures price change when there is no change in volatility. (While it is difficult to imagine a case where a futures price change of this magnitude would not cause a volatility shift, this artificial example makes a useful point.) Puts increase in value when futures prices fall, and the Scenario 3 put prices are based on a futures price drop to 111-30, the passage of 14 days, and no change in volatility.

Approaching the Options Trading Real World

When describing how options work, it is convenient to isolate such factors as time, future price, and implied volatility change to the extent possible, as has been done in Scenarios 1, 2, and 3 of Exhibit 1. This helps you see how much influence these pricing factors can exert on the price of the option.

The reality is that these pricing factors interact. They can work against each other—as in Scenarios 2 and 3 where the positive effects (positive from the point of view of an option buyer) of volatility change and futures price change, respectively, can overcome the negative effect of time decay. Scenario 4 shows what can happen when several of these factors work together.

The assumptions behind Scenario 4 are that the futures price has dropped 2-25, from 114-23 to 111-30, and the implied volatility has soared from 7.5 percent to 10.8 percent. This futures price-implied volatility interaction can drive large option price increases. Indeed, the Scenario 4 results appear to be greater than the sum of the parts.

Consider Exhibit 2, which shows the percent change in the put prices in these four scenarios. (Note that percent changes result from dividing the values in the change columns by the initial option price. Consider the 111 put in Scenario 1: -5 price change ÷ 7 initial price = 0.71429, or 71.4 percent.)

Exhibit 2: Percent Changes in Put Prices
	Scenario 1	Scenario 2	Scenario 3	Scenario 4
111 put	-71.4	57.1	329	643
112 put	-53.3	40.0	280	440
113 put	-39.3	32.1	243	321

The percent changes for Scenario 4 are much larger than those for Scenario 3. Notice that the options that were initially farther out of the money outperformed, in percentage terms, the options that were closer to the money. This will always be the case.

These exhibits underscore the importance of a notion common among options traders: Where a futures trader must have an opinion about price direction, an options trader must also have an opinion about the direction of implied volatility. But that is a topic for another time.

Keith Schap is a Senior Writer in Business Development at the Chicago Board of Trade.

Laura Oatney is editor of LindForum. She can be reached at editor@Lind-Waldock.com.

Futures trading and options on futures trading involve a substantial risk of loss, including more than the original investment, and thus may not be suitable for all investors.

The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations.

© 2003 Lind-Waldock, A Division of Man Financial Inc. All Rights Reserved. Futures Trading Involves Risk of Loss.