March 24, 2016
Earlier this week, Roger Scott’s WealthPress, published a piece on implied and historical volatility. The article outlined the importance of volatility and how this affects the price of stocks and options.
What is Volatility?
According to WealthPress, “volatility means movement of the underlying asset.” In short, volatility measures how unpredictable and unstable the stock market is. For example, if the market rose and fell more than 5% in a matter of a few trading days then the market would be considered volatile.
Roger describes historic volatility as “how much the asset moved on a daily basis over a specified period of time in the past while implied volatility is derived directly from the option’s actual market price and shows what the market “implies” about the underlying assets volatility, ”
Ultimately, historic volatility analyzes past behavior of the asset in hopes of predicting future behavior while implied volatility analyzes the pricing model.
How does volatility affect Options Pricing?
An option is a derivative of a stock or underlying asset. This means that the higher the price of the stock, the higher the price of the option. Volatility is no different and has a direct correlation. This means that when volatility increases the price of the stock it therefore also increases the price of the option.
According to Roger, when a particular stock has higher historic volatility, the price of the option would be higher, because a stock that has moved substantially over time, has a higher chance of continued movement. Conversely, when a stock has low historical volatility, the option would have a lower price, because there’s a lower chance that the option will move substantially and as a result the option buyer has less chance to profit.
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