The Impact of Volatility on Option Pricing

Volatility is one of THE defining characteristics of an Option’s price.

It is incredibly important to know the ins-and-outs of implied volatility and the impact it has on the price of an Option if you’re looking for a way to navigate around the Options market and also make a profit on the side.

But first, what does one mean by the ‘price’ of the Option?

A premium is the price you pay when you buy an Option.

But what exactly happens under the hood when someone is putting a price-tag on an Option?

How is an Option priced?

An Option is priced on top of 2 things, the intrinsic value and the time value of the Option.

Intrinsic value is essentially a value which is obtained after calculating the difference between the Option’s strike price and the price of the underlying stock.

Time value is just a way of monetarily factoring in the amount of time left until the Option reaches its expiry date.

The interplay of the following factors ends up deciding the premium which you will pay before buying the Option:

• Price of the underlying asset
• Strike price
• Time until the Option gets expired
• Interest rates
• Dividends (if any)
• Implied volatility

Implied volatility happens to have the most weight in influencing the price of an Option apart from intrinsic value and time value, but why is that so?

What does volatility mean?

Volatility is somewhat synonymous with uncertainty, or unpredictability, which very well is the case when you’re talking about the stock market.

Put simply, volatility is the amount by which the stock price fluctuates irrespective of the direction of this fluctuation.

Implied volatility

Implied volatility is the volatility which the market-sentiment is implying regarding the future outlook of a stock.

This implication is being made by traders in real-time as the stock price moves up and down.

It turns out that implied volatility piques the interest of traders as it reflects the future of the Option’s price thereby enabling them to better place their bets and fortify their portfolios.

The origins of implied volatility

The market presents itself with a large serving of truth alongside a little sprinkle of news/rumours or vice-versa when it comes to stock prices and consequently, Option prices as well.

Implied volatility is a consequence of traders in the market tweaking their trading patterns and habits as news/rumours like a major court decision for a particular company, earnings announcements, bankruptcy or anything which may influence the stock price makes it to the ears of traders.

These traders, due to their large numbers end up shifting the supply-demand balance for a particular stock impacting its price and thereby the Options having those stocks as their underlying as well.

Impact of implied volatility on Option prices

Implied volatility increases as the demand of an Option increases and as a result, the price of the Option increases.

So, if the implied volatility increases, its good if you’re the Option owner and bad if you’re the Option seller.

Conversely, implied volatility decreases if the demand of the Option drops down in the market and consequently the price of the Option reduces as well, which is good if you’re the Option seller and bad if you’re the Option owner.

The bottom line is that volatility and Option-prices are directly proportional to each other.

But why is this the case?

This is because Options are exactly what they are, letter for letter.

The Option buyer can either choose to exercise the Option when it is favourable or omit exercising the Option if the price fluctuation is not in their favour. So, when higher volatility is observed, both the upside risk and downside risk increase.

On an ending note, remember that when the underlying asset in an Option displays higher volatility, there is an increase in the price of the Option, irrespective of the Option being either a Put or a Call.

When the upside risk is high, the Call-Option buyers end up making a profit, and conversely when the downside risk is high, the Put-Option buyers make a profit.

So, you should try to buy Options when implied volatility is low as you can buy them at a rather low price.

And you should sell Options when the implied volatility is high due to them becoming less attractive to purchase as a result of the expensive premiums.

By keeping in mind the above factors and implementing them in unison, you can very well forecast trends and volatility better so as to stay on the winning side by staying away from both, buying overpriced Options and selling under-priced ones.

Key takeaways:

• Volatility is the amount by which the stock price fluctuates irrespective of the direction of this fluctuation. Implied volatility is the volatility which the market-sentiment is implying regarding the future outlook of a stock.
• Volatility and Option-prices are directly proportional to each other.
• Buy Options when implied volatility is low (due to low premiums)
• Sell Options when implied volatility is high (not many will buy at an expensive premium, better to sell)