Option traders love to look at and discuss volatility (vol). Many option traders monitor the Cboe Volatility Index® (VIX)1 and attempt to select an appropriate options trading strategy for a given level of implied volatility2 (IV).
Mechanically, vol can impact the price of an option. Implied volatility, for example, is derived from current options prices via a pricing model. So vol can inform traders about options prices. But traders shouldn't be misled: Price and vol are not equal.
Viewing vol through a slightly different lens could help clear up some misunderstandings and help traders see how vol can be a trader's friend when buying stocks or selling options. Volatility is a forecast that indicates the state of the market and stock at the present moment. Keep in mind, those expectations can change, sometimes very quickly.
Options volatility and trading capital
Stocks with prices above $500 per share—the kind that can move $20 or more in the course of a typical trading day—attract a lot of attention. After all, a $20 move can mean a lot of money. If a trader owns 100 shares of such a stock, that's a $2,000 move. But is all the opportunity, or the risks, in high-priced stocks?
No. Those $20 moves may be impressive, but don't confuse dollar changes with percentage changes, which is what vol is all about. Let's do a little math:
- If volatility is 20%, that means theoretically the price of the stock is expected to be between +/– 20% from its current price 68% of the time (one standard deviation) in one year.
- If the current stock price is $600, that 20% translates into +/– $120.
- If the stock price is $50, 20% is +/– $10.
So, a $2 move in a $50 stock is a larger percentage change (4%) than a $20 move in a $600 stock (3.3%). If a trader invested, say, $5,000 in each trade in this example, they would've seen more profit (or loss) with the $50 stock because they'd control more shares.
To take this one step further, because stock price is an important variable in any options pricing model, the options prices on a higher-priced stock will generally be greater than the options prices on a lower-priced stock—volatility and all other things being equal. A trader will likely see out-of-the-money3 (OTM) options on a $600 stock with high premiums compared to the OTM options on a $50 stock. But trading a high-priced option on a high-priced stock doesn't necessarily mean the option trader can make more. The capital requirement on those high-priced stocks can be a problem.
The capital requirement on a short put4, for example, is based in part on the stock price. This is because the risk in a short put is the strike price down to $0 minus the premium received. The higher the stock price, the larger the required capital to short a put. Is the option trader using their trading capital efficiently if they're selling high-priced options on high-priced stocks? Not necessarily. If the options on a $50 stock have higher IV than the options on a $600 stock, the option trader might consider shorting 10 OTM puts on the $50 stock rather than one OTM put on the $600 stock.
In fact, for the same amount of capital required to short an option on a high-priced stock, a trader might consider either trading more contracts of a lower-priced stock with higher volatility or trading fewer contracts, which requires less capital and lets them diversify more.
Looking at volatility from the perspective of trading capital could help you realize you don't necessarily have to go after big swings in high-priced stocks.
Volatility index and implied volatility
If stock XYZ's options have an overall IV of 40%, is that high or low? It's hard to tell without understanding the volatility range the stock has had in the past. Many traders monitor the VIX (which is a measure of the IV of SPX options) and compare it to the volatility of an individual stock. But if the VIX is 15%, does that mean that 30% volatility in a stock is high? Not necessarily. It's important to compare the stock's current IV to past IV to better judge if it's high or low.
From the Trade tab on the thinkorswim® platform, enter a stock symbol and scroll down to Today's Options Statistics (see image below). The Current IV Percentile shows the day's IV compared to the high and low range for the past 12 months. A 50th percentile means IV is exactly in between the high and low values. A percentile closer to 0% means vol is low and closer to 100% means vol is high relative to where it's been.
Source: thinkorswim platform
For illustrative purposes only. Past performance does not guarantee future results.
Traders can pull up an implied volatility chart to see IV on different time frames. From the Charts tab, enter a symbol. At the top right, select Studies, then Add study > All Studies > H-L > ImpVolatility from the drop-down menu. Traders can compare the current IV to its high and low values for short- and long-term ranges.
Volatility through a probability lens
Many retail traders routinely use the probability of an option expiring in the money5 (ITM) or OTM to choose a trading strategy. But are equal probabilities actually equal? The simple way to answer this question is to look at the Analyze or Trade tab on thinkorswim, and from the Layout menu in the Option Chain, display the Probability OTM and Probability ITM.
For example, take two stocks, MNKY and FAHN, both of which are trading at $100. If the MNKY December 95 put has a 70% probability of expiring worthless, and the FAHN December 90 put also has a 70% probability of expiring worthless, this indicates the IV of the FAHN options is higher than the IV of the MNKY options. A higher volatility implies a larger potential percentage price change in the stock price. And the more likely a stock will make a large move, the higher the probability a further OTM strike might be ITM at expiration. (Keep in mind, probability is theoretical and isn't a guarantee of future performance.)
With higher volatility, FAHN is more likely to rise or fall 10 points than MNKY. And the market suggests that the price of MNKY may fluctuate less. So, the strike prices that are closer to the current stock price of MNKY may have a higher probability of expiring worthless. In this way, the volatility of different stocks translates into a probability representing the market's estimate of how large the magnitude of the potential price changes might be in a particular stock.
The bottom line
The vol of a stock or market doesn't tell the whole story. Vol needs to be viewed through the practical trading lenses of capital requirements, implied volatility comparisons, and probability. This new set of lenses, along with an understanding of how high or low volatility is relative to where it's been, may help option traders determine both a volatility that presents a potential trading opportunity and a strategy that aligns with the volatility of a particular stock.
1An index that measures the implied volatility of the S&P 500® index (SPX) options. Otherwise known to the public as the "fear" index, it's most often used to gauge the level of fear or complacency in a market over a specified period of time. Typically, as the VIX rises, options buying activity increases, and options premiums on the SPX increase as well. As the VIX declines, options buying activity decreases. The assumption is that greater options activity means the market is buying up hedges in anticipation of a correction. However, the market can move higher or lower, despite a rising VIX.
2The market's perception of the future volatility of the underlying security directly reflected in the options premium. Implied volatility is an annualized number expressed as a percentage (such as 25%), is forward-looking, and can change.
3Describes an option with no intrinsic value. A call option is out of the money (OTM) if its strike price is above the price of the underlying stock. A put option is OTM if its strike price is below the price of the underlying stock.
4A bullish strategy in which a put option is sold for a credit, usually at a strike price below the current price. This may be done with a goal of the stock staying above the strike price and the option expiring worthless and the premium collected. Or it may be done with a goal of being assigned the stock at the lower strike price. The risk is that the stock is assigned and then falls in value, bringing the total risk of the strike price to $0.
5Describes an option with intrinsic value (not just time value). A call option is in the money (ITM) if the underlying asset's price is above the strike price. A put option is ITM if the underlying asset's price is below the strike price. For calls, it's any strike lower than the price of the underlying asset. For puts, it's any strike that's higher.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options". Supporting documentation for any claims or statistical information is available upon request.
Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.
All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request.
Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Past performance is no guarantee of future results.
Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring.0823-3K5F