The value of options depends on more than just the price of their underlying assets. This is what gives options a unique character among all tradable instruments. Whether we believe that the price of an asset will go up, down, sideways, or even if we have no opinion at all about price movement, there are option strategies that we can use.
The main determinants of option prices are a) the current price of the underlying asset, in relation to the strike price of the option; b) how much time remains in the option’s life; and c) how fast option buyers and sellers expect the underlying asset’s price to move.
All other things being equal, assets whose prices move faster have more expensive options. And, for a given asset, if expectations for its price rate of change increase, prices for its options will increase, even if the underlying price has not yet moved at all. The reverse is also true – an underlying that is expected to slow down will see its option prices decrease. Implied volatility is the name we give to this variability in option prices due to expectations. By paying higher prices for options, people imply that they expect the underlying to move faster, or vice versa.
Implied volatility (IV) is expressed in terms of an “expected” annual percentage rate of change. “Expected” is in quotes, because it’s the rate of change that would have to happen in the future for its actual option prices to make sense. IV varies by asset – as of this writing, the IV of the S&P 500 is 14%; that of the Russell 2000 is 19%, and that of a very volatile stock, RVBD, is 77%.
IV is constantly changing for every asset. When it gets abnormally high or low for that asset, the best bet is that it will go back to normal… Continue Reading
