Importance of Implied Volatility in Option Pricing

Implied volatility is a force in itself. This means than an option contract could gain or lose value purely on the market’s changing expectation of volatility even if the underlying stock price doesn’t move at all. 

There are not many financial products that are priced so aggressively on the future expectation of volatility as with option contracts.

Assume that a stock is trading at 100/share right now. You are given the choice to purchase a 105 strike call option that expires one month from today. At the end of the month, if the price of the stock is above your strike price of 105 then you could make money. So, the question becomes; how much would you pay for this 105 strike call option contract?

Tough question right? Now let’s introduce two different volatility scenarios.

In the first scenario, let’s assume that this stock is an average mover historically, moving maybe 5% per month on average. If this were the case moving forward, maybe the most market participants would expect the

stock to move in the next month would be the same 5%. That’s an expected range of about 5 up or down each year 68% of the time.

How valuable is the 105 strike call option to you now? Probably not

worth anything at all because the likelihood of actually seeing a profit is

incredibly small. This is like a lottery ticket where the chance of winning is low, so the price is low and creates a sort of lure due to buy due to the low price.

Assuming that this is a mid-cap stock, moving as much as 10% in a month. In this case, because the market might expect the same type of volatility in the future, the new expected range over the next year is now 10 up or down. That means there is a 68% chance the stock trades between 90 and 110 before your call option contract reaches its expiration date.

So, now the same strike of 105 is much more interesting to look at Naturally, if the stock is expected to swing wildly in the future than the price of options on both sides, calls and puts, would be higher because traders expect a higher chance of making money.

So, higher the implied volatility; higher the option price and lower the implied volatility; lower the price.

This is not one-sided here meaning all option values increase, on both sides for calls and puts, with higher implied volatility like a tide raising all ships at sea. And, market expectations of implied volatility change day by day as new information about the company, their industry, the economy, etc. comes out and is made public. Everything that is known or assumed is priced into the future implied volatility estimate. 

Happy Trading!!!

Cheers.