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Volatility’s Impact When Hedging Market Exposure

Richard Croft
March 16, 2016
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Volatility’s Impact When Hedging Market Exposure

Volatility represents the underlying stock price fluctuation, not the price trend. The degree of fluctuation can vary whether a stock’s price trend is bullish and advancing, bearish and declining, or remains in a steady range over time.

Historical volatility can be calculated based on a stock’s actual past trading history and reflects a range of closing prices over a given time period, usually one year. It can be measured as the annualized standard deviation on returns.

Implied volatility is that volatility measurement that produces an option’s actual market price as its theoretical value.

Implied volatility represents a market consensus on a stock’s future volatility. In other words, it is the expected volatility of the underlying stock implied by the marketplace as it currently values an overlying option. And because it is a collective effect of the numbers and opinions of all buyers and sellers in the marketplace, implied volatility can change often during the lifetime of an option.

As implied volatility increases, call and put prices also increase, and as it falls, they fall as well. Implied volatility is dynamic. It can increase or decrease during an option’s lifetime and lead to unexpected profit or loss.

When you’re considering the purchase or sale of an option today, you’re as much concerned with where the underlying stock will or could be trading in the future. Volatility assumption is by nature subjective. If you have an estimation about an underlying stock’s future volatility level, you can use this measure in an option pricing model, such as the well-known Black-Scholes model, to compare its current market price to its theoretical value. Any difference between the two will be your relative gauge of how overpriced or underpriced that option may be.

To determine an option’s implied volatility, you can use MX options pricing calculator.

Change in the actual, observed volatility of the underlying stock may or may not result in changing option prices, depending on the marketplace’s response.

A change in implied volatility, on the other hand, by definition, results in changing option prices, impacting the profitability of your positions.

Assessing values and choosing strategies

If implied volatility levels are lower than usual—that is, the options appear relatively undervalued—investors might choose strategies that involve long options positions. For instance, if they’re bullish on an underlying stock, they may buy calls.

On the other hand, if volatility levels seem to be high at the time, and the options seem overvalued, investors might choose strategies that use short options. If they’re still bullish on the stock, they may choose to sell cash-secured puts or covered calls.

For further details on the strategies mentioned, please visit our section Guides and strategies under the Education tab, at m-x.ca.

Buying options that are undervalued or selling those that are overvalued because of current implied volatility level by no means guarantees profits. For long option positions before expiration, increasing implied volatility has a positive effect on potential profits. For short positions, decreasing volatility has a positive effect.

Trading implied volatility means focusing primarily on a favourable change in an option’s volatility level to achieve a profit. So when you establish an option’s position, you want to understand what you’re really relying on more for profit—sustained up or down movement in the underlying stock price or fluctuating implied volatility levels.

Changing implied volatility level might be considered a market within the market. It can present a picture of the marketplace’s collective forecast of the risk that an underlying stock will trade in a wider range in the future.

If your focus is to trade volatility as many professionals do, you should follow the option market closely and be familiar with current and historical implied volatility levels for any underlying stock and its options.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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