As we've mentioned earlier, the price of an option is determined by several main factors.
Some of them could be observed directly from the market, while others are expected to be relatively stable. And there's one big uncertainty—volatility.
Understanding volatility is very important to options trading.
So, what is volatility exactly?
Volatility is the magnitude of price changes of an underlying asset (e.g., a stock). It's usually presented in a percentage.
If the stock price goes up or down dramatically, we say it's volatile.
If its price doesn't change much, it's not so volatile.
All else being equal, the higher the volatility of the underlying stock, the higher the value of its options in theory.
That's because with the strike price agreed in advance, the more volatile the stock is, the more likely it reaches the strike price, so the option is more likely to be exercised.
As investors, we know that the future matters more than the past. The same is true with volatility.
We use "historical volatility" to measure how much the price of a stock changes in a given period of time.
But what's more important is its "Implied volatility", a metric that looks into the future, as we've mentioned earlier.
Implied volatility refers to the market's expectation of how much the underlying stock will move, which is reflected in the price of its options.
A trader who just cares about historical volatility is like a driver who only looks into the rearview mirror. The consequences could be pretty serious.
When making options trades, it's necessary to gaze into the future, which means taking implied volatility into account.
What can implied volatility tell us?
Suppose there is an option with an implied volatility of 40%, and the underlying stock is trading at $100.
It suggests the stock has the potential to trade between $60 and $140 over the next 12 months, up or down by 40%.
When the market expects the stock price to move considerably, implied volatility tends to rise, so does the option premium.
Conversely, if the stock price is expected to be more stable, implied volatility and the premium will fall.
Volatility tends to rise sharply before major events, such as earnings releases, and the Federal Open Market Committee (FOMC) meetings, with options premiums moving up correspondingly.
But after these market-moving events, volatility generally falls back quickly, driving down premiums.
Therefore, we can explain why sometimes the price of a call option doesn't move in line with the soaring stock.
This situation is known as "volatility crush".
Think about volatility like a swing-vigorous movements cannot last long. It will return to "stable" levels, which is "mean-reversion" in trader-speak.
So volatility will gradually move back to its historical average over time.
For options traders, it's a good idea to be mindful about buying options with inflated implied volatility, as they are likely to be overpriced, and their prices may easily stumble.
Implied volatility also plays a crucial role in evaluating the relative value of options.
Generally speaking, the higher the implied volatility for options of the same underlying stock, the more likely its premiums are overvalued.
Likewise, the lower the implied volatility, the more likely its premiums are undervalued.
Suppose a call option premium trades at $3 on a given day, with the underlying stock price at $50 and the implied volatility being 30%.
After some time, the premium rises to $5 as the stock price goes up to $53, but the implied volatility falls to 28%.
In this case, the call's premium increases as the stock price rises.
However, given that the implied volatility decreases, many traders would argue that the call becomes cheaper in relative terms.
So here's a tip: by comparing the implied volatility of the option with the stock's historical volatility, we could have an idea of whether the current implied volatility is reasonable or not, thus deciding whether the option is cheap or overpriced.
You can access the analysis about volatility on moomoo app by following the steps below:
Enter the "Detailed Quotes" page.
Tap the "Options" tab.
Select an option and enter its "Detailed Quotes" page.
And tap "Analyses".
Okay, so much for volatility.
In the next chapter, we will talk about how to trade options.
See you next time.