Call Options

What Is Volatility?

An essential element determining the level of option prices, volatility is a measure of the rate and magnitude of the change of prices (up or down) of the underlying. If volatility is high, the premium on the option will be relatively high, and vice versa. Once you have a measure of statistical volatility (SV) for any underlying, you can plug the value into a standard options pricing model and calculate the fair market value of an option.

A model's fair market value, however, is often out of line with the actual market value for that same option. This is known as option mispricing. What does this all mean? To answer this question, we need to look closer at the role IV plays in the equation.

What good is a model of option pricing when an option's price often deviates from the model's price (that is, its theoretical value)? The answer can be found in the amount of expected volatility (implied volatility) the market is pricing into the option. Option models calculate IV using SV and current market prices. For instance, if the price of an option should be three points in premium price and the option price today is at four, the additional premium is attributed to IV pricing. IV is determined after plugging in current market prices of options, usually an average of the two nearest just out-of-the-money option strike prices. Let's take a look at an example using cotton call options to explain how this works.

Sell Overvalued Options, Buy Undervalued Options

Let's take a look at these concepts in action to see how they can be put to use. Fortunately, today's options software can do most all the work for us, so you don't need to be a math wizard or an Excel spreadsheet guru writing algorithms to calculate IV and SV. Using the scanning tool in OptionsVue 5 Options Analysis Software, we can set search criteria for options that are showing both high historical volatility (recent price changes that have been relatively fast and big) and high implied...