The inputs needed to price a stock option include: number of days to expiration, risk-free interest rate, volatility, the price of the underlying stock, dividend date and amount, and the option strike price. Out of the all the inputs, only volatility is derived by the market place. It’s simple supply and demand. If demand for options is high, volatility rises. On the other hand, if demand is low and traders are more interested in selling options, then volatility drops.
What are some examples of when the demand for options can be high?
An easy one to understand is during a market crash. Imagine being long a boatload of stocks. Instead of selling the entire portfolio, professionals will go into the options market and buy “put protection” to hedge against further downside. This demand for options causes the prices of options to be worth more.
During good times, traders are more focused on extracting the most out of the market as possible. Instead of paying for protection, they may decide to sell options and collect a premium because they are more concerned about missing out than hedging. This constant selling pressure drives the prices of options lower, and hence the option volatility drops.
How Important Is Understanding Option Volatility?
If you don’t believe me, let’s take a look at the biggest stock on the planet, Apple.
According to CBOE LIVEVOL, Apple options had an option “implied” volatility ranging from 15.4% to 42.3% over the course of a year.
Let’s just take a quick look at what this means with the use of an options calculator. In this example, we’ll assume that Apple has no dividends and have these inputs:
As you can see, we can not get a price for the options until we input a volatility number. So let’s first use the lowest range, 15.4%
With 30 days to expiration, the price of the near at-the-money calls are $2.06 per contract. Each contract leverages 100 shares, so the total cost is $206 per contract.
Now, let’s take a look at how much these same calls would cost if we bumped up the volatility to it’s 52-week high.
The same exact call options at a 42.3% implied volatility are priced at $5.69 per contract. Each contract leverages 100 shares, so the total cost is $569 for one contract.
The difference between the two extremes are roughly 276%. Now, the 52-week range for the stock was $88.53-$118.08…clearly a much greater range from the options compared to the stock price.
Generally, traders will compare volatilities over a period of time to get a sense if they are priced relatively fair, cheap, or expensive. If you’re not familiar with these concepts, then it’s probably best that you stick to option spreads. Option spreads allow you to mitigate the role that implied volatility has on the price of an option. With more experience, you’ll be able to know what the ideal strategy is by observing the option implied volatility. After all, there are times when buying premium makes more sense than selling it, and vice versa.