How to Use Implied Volatility
By Lind-Waldock ISSUE 306 | JULY 2004
While options can be a versatile and valuable part of your investment strategy, trading them can sometimes be tricky. After all, about 80 percent of all options expire worthless. With that in mind, you should just sell premium, sit back and collect the money, right? Unfortunately, it's not that easy. So, how can the average trader level the playing field? How do you know when to buy options and when to write, or sell, options?
The first thing you should do before entering into an option strategy is assess the market value of an option. One way that can be done is by figuring the option's implied volatility. Volatility is a measure of the rate and degree of price change for the underlying future. Simply put, it's a gauge of how sharp the market may rise or fall in any given time. High volatility typically indicates an unstable environment with large price swings in a short period of time, while low volatility indicates less movement and more stable conditions.
Implied volatility is the amount of expected volatility the market is pricing into an option. For example, if an option should be trading at 10 points based on time and intrinsic value but is actually trading at 15 points, the additional five points in premium can be attributed to implied volatility. In this example, the option is overpriced by at least five points and may be suitable for writing. If an option is trading at five points but should be trading around 10, implied volatility is low on that option. That means it is likely undervalued and may be a good buy.
This all sounds very simple--buy undervalued options and sell overvalued options. The trick is determining the fair market value of an option. In 1973, Fisher Black and Myron Scholes improved on a previous pricing model developed by A. James Boness. Today, this is of course called the Black Scholes Model of option pricing. These distinguished gentlemen were accomplished mathematicians that spent long, arduous hours developing their model. Fortunately, today Internet access and software programs do the work for us. A few strokes of the keyboard in your favorite search engine can yield dozens of Web sites that provide fair market value and implied volatility option calculators. A small investment in some good software can pay dividends on future option trades.
The bottom line is that you want to give yourself every possible advantage when investing your money. If you look at the way most successful investors approach trading, you will notice a big difference from the approach of the average person.
Think of using implied volatility in the same way that you use a real estate agent when buying a house. You tell the agent what area you want to live in and the agent then goes out and determines fair market value of the houses in that area. The agent then helps you conclude which houses are below market value and therefore a good purchase, and which are overvalued and not worth looking at. Implied volatility works similarly in figuring the correct options to buy or sell based on their value.
Keep in mind that a good broker can act in the same capacity as the real estate agent in my example. It is great to have the software that I spoke about previously to help you evaluate the proper option to buy or sell, but there are other variables that factor into the underlying instrument that you may not be aware of. The assistance of a qualified broker and the proper knowledge of how the markets work can help improve your chances of being a successful trader.
In conclusion let me offer this warning. Throughout this article I have addressed writing, or selling, naked options. This type of strategy involves a high degree of risk and is not suitable for the novice investor. When you buy an option you are working with a clearly defined risk. You pay for the premium and the commission and the worst that can happen is the option goes to zero and you lose your initial investment. When you sell an option your risk is unlimited. The option can go against you an infinite amount and your losses can be severe. Please consult with a professional advisor before employing this strategy.
Kristina Zurla Landgraf is editor of LindForum. She can be reached at editor@Lind-Waldock.com.
Futures trading involves risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
© 2004 Lind-Waldock, A Division of Man Financial Inc. All Rights Reserved. Futures Trading Involves Risk of Loss.
