The Basics of Option Volatility

13 September, 2016

When it comes to buying and selling options, most traders, whether beginners or experts, know a little about the Black-Scholes model of option pricing. The Black-Scholes model was established in 1973 to help traders determine what the market value of an option was based on expiration time, strike price and historical volatility.

When determining the fair price of their options, many traders don’t use this or even the option calculator for that matter.

This type of behaviour generally occurs because traders believe that an option’s value can increase when a call or put option is exercised. There are however, certain variables that can get in the way.

Think about this for a moment; will you purchase any item without researching the neighbourhood to find out the real market price? You wouldn’t of course because you wouldn’t want to pay more than the value of the commodity. In the case of options, deciding to purchase without careful assessment can actually lead to a lower option value because the expected move of the derivative has already been factored into the price.

If you really want to understand the mysteries of option pricing and understand why careful assessment is needed, you need to take a good look at volatility. Let us now examine what volatility is and how it can affect option pricing.

Understanding Option Volatility

You can use volatility to calculate option pricing which will give you an idea on magnitude and rate of the price change of a derivative. This refers to both changes that increase and decrease. In a nutshell, when the volatility is high, the price of an option is high, but when it is low, the option’s premium will show it.

Volatility are of two types:

The Historical Volatility- This is a type of volatility that refers to the known changes in an option’s price. This type of volatility has a rate of change, similar to a car speeding down the road. However, while we can measure the speed of a car in hourly rates, that of changing rate takes a year. If the derivative has been moving along at a certain rate per year, we can theoretically expect it to move at the same rate in the future. Also, this accounts for trend or direction.

Learn How To Turn Volatility To The Profit Of Your Option Pricing- The Implied Volatility- The implied volatility uses the historical data and the current market prices to determine the option price. You can then calculate the current price using two of the closet out-of-the-money strike prices. This type of volatility has a huge affect on the price of options, which may be because it depends largely on the activity of the marketplace. To this end, when the implied volatility increases, the option prices does too.

If you like trading currency or stocks, it is necessary that you are getting the fair market price for your options. Take the time to assess the option pricing and derivative and determine what the historical and implied volatilities are using as an option calculator. Hand your option pricing and financial management issues to HedgeBook!

If you are a company managing rate swaps and financial derivatives, Hedgebook is the perfect evaluation and reporting tool. It is the key tool for interest rate swap risk management processes.

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