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Beware Volatility

Jason Ayres
June 11, 2013
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8 minutes read
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Option traders have been enjoying a period of low implied volatility for quite some time now. Periods of low implied volatility make option buying attractive as premiums trade at relative lows comparative to periods when implied volatility is high.

In order to understand the implied volatility variable, we first have to consider the concept of volatility in general. As an option trader, there are two types of volatility we must be aware of. We have already touched base on implied volatility, however we must also consider the historic volatility of the stock.

Historic volatility is a quantifiable measure of the average deviation of the share price from its statistical average price over a period of time. This number will change as the price action changes over a period of time, but the general consideration is that the higher the number, the more volatile the stock. For example, consider these two securities trading within a similar price range

Research In Motion (BB) is trading at $14.20/share and has an annual historic volatility of 43% while the ETF iShares S&P/TSX 60 Index Fund (XIU) trading at $17.80/share has a current annual historic volatility of 11%. This indicates that the XIU is less volatile then BB.

This difference alone will result in BB options trading at a higher premium than those of the XIU. While we can’t make an exact comparative analysis, consider the Research In Motion (BB) 15 strike, at-the-money call option expiring in July asking $1.05 while the XIU July 18 strike at-the-money call option asking $0.21.

Even during periods of low implied volatility, options are still priced based on their probability of being in-the-money on expiration. As a result, the more volatile the stock or ETF, the higher the probability that the shares will move enough for the option to be in-the-money and subsequently the higher the ask price for the option.

I typically explain it like car insurance. For example, a driver with little driving experience who has just purchased a brand new sports car falls into a category that statistically has a higher probability of getting into an accident. As a result, the insurance company must hedge that risk in part by requiring a higher premium. Comparatively someone with 3 children, 30 years of driving experience and a minivan falls into a category of less risk and will enjoy lower premiums as they are statistically less probable to get into an accident.

Now back to the markets. During the last year, stocks have gone up and stocks have gone down, however risk consideration has been at a low. While every stock has their own “personality” for the most part, market makers have been pricing options comparable to the stocks historic volatility.

This would suggest that implied or “expected” volatility was in line with historic volatility for the most part. This relationship will change as market makers begin to anticipate an increase in risk. For example, even if the share price hasn’t changed an earnings report, product launch, law suit or overall economic uncertainty can suggest more risk. Since the market makers job is to take the opposite of any trade, they need to get paid for the increased uncertainty. As a result, option premiums will increase.

Consider the VIXC. This is Canada’s volatility index. The VIXC estimates the 30-day volatility of the stock market that is implied by the near-term and next-term options on the S&P/TSX 60 index. In other words this index can give the investor a general overview of implied volatility as it relates to historic volatility.

The below chart indicates that as of the last few weeks, implied volatility has been creeping higher as more risk has entered into the market. This can be determined by observing that the blue line representing implied volatility is now above the red line which indicates the S&P/TSX 60.

VIXC June 11

This is a general indication that option premiums are getting more expensive and suggests that the investor may want to consider strategies that help offset the cost of volatility, such as Bull Call Spreads and Bear Put Spreads for directional trades and Collars (sell calls/buy puts) for protecting stock positions at a reduced cost.

Investors should consider the unique implied/historic volatility relationship for each stock. A general rule of thumb is to consider options to be priced fairly if implied volatility is below or close to historic volatility. Conversely options could be considered expensive if current implied volatility is above historic. Under this circumstance, the option buyer may look to offset volatility by creating a debit spread or exploit “overpriced” options by implementing a credit spread.

For example, currently Research In Motion (BB) has an annual historic volatility of 43% while an at-the- money July call is reflecting an implied volatility of 67%. This suggests the option is pricing in the stocks potential to be more volatile than it has been. A spread may be considered to mitigate this. How does that make a difference? The buyer of the option runs the risk of overpaying for the option and losing money on a contraction of volatility, while the seller of an option will benefit for this contraction. The spread involves being a buyer and a seller, therefore neutralizing the impact of implied volatility changes.

Tim Hortons Inc (THI) is exhibiting an annual historic volatility of 23% with a July at-the-money call reflecting a current implied volatility of 16%. This indicates that this option is relatively cheap based on the relationship of the options implied volatility to the stocks historic volatility. The investor may simply decide to buy an option contract and benefit from a move in the stock as well as a possible expansion of implied volatility.

Implied volatility is typically one of the most overlooked and misunderstood of all of the option pricing variables. By understanding the basics, the active investor can help put the odds in their favour by ensuring they are selecting the most appropriate strategy for the current market conditions.

For more insight into this important pricing variable watch the following educational video How Volatility Influences Your Option Value

Jason Ayres
Jason Ayres http://www.croftgroup.com/

CEO and Director of Business Development

R.N. Croft Financial Group

Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for Learn-To-Trade.com and an instructor for the TMX Montreal Exchange.

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