Answer :In our last Article, we discussed the concept of Volatility, how is it calculated, how is it interpreted and what period of time should be reckoned for such calculations.

Question :How can these learnings be applied?

Answer :Study of past prices of a scrip will enable you to arrive at ‘historical’ volatility. Option prices as you are aware, depend on Volatility to a high degree. However, Option prices may or may not reflect ‘historical’ volatility.

Study of past prices of a scrip will enable you to arrive at ‘historical’ volatility. Option prices as you are aware, depend on Volatility to a high degree. However, Option prices may or may not reflect ‘historical’ volatility.

Question :Why not?

Answer :It is possible that market participants believe that Volatility in future is expected to rise. Thus, historical Volatility may have been 50%, but it is widely believed that the scrip will become more Volatility resulting in a higher level of say 60%. Accordingly, the Option might be priced on the basis of 60% forecasted Volatility.

Question :How will I know this?

Answer :If you study the price of the Option as actually quoted in the market, you will realize what is the ‘implied’ Volatility. For example, if the following Option is theoretically studied:

Stock Price Rs 280

Strike Price Rs 260

Volatility 50% annual

Days to Expiry 20 days

Interest Rate 12% annual

The price of the Option applying Black-Scholes Model comes to Rs 26.28. But the actual price of that Option in the market might be (say) Rs 29.50.

Question :What does this imply?

Answer :This could imply that the market is not going by the historical Volatility of 50%, but is imputing another Volatility to that Option going forward. You can use the same calculator, but now instead of providing the Volatility figure yourself, you can provide the Option price instead. Now if you work backwards and find out what is the Volatility that would support the price of Rs 29.50, that Volatility comes to 65%.

Question :So how can I use this understanding?

Answer :You are facing a situation where historical Volatility of the scrip is 50%, but the implied Volatility is 65%. Various possibilities for this divergence can emerge. One possibility is that the market is expecting the future Volatility of the scrip to increase and is accordingly factoring in such expectations. Another possibility is that the market is mis-pricing the Option and that the Option value will come back to around Rs 26.28 shortly. The third possibility could be that there is some news about the company that could affect the price favourably and this news is being reflected in the Options become more expensive to begin with and in a short time, the underlying scrip will also reflect this phenomenon.

Depending on what you see from these possibilities (and there could be others too), you could take an appropriate stand.

For example, if you believe that Volatility will rise, you could go in for Option Strategies that could suit such an event happening. If you believe that the Option is being mispriced, as an aggressive player, you could sell such Options with a belief that you could buy them back at a later date. Such a strategy would need to be supported by a hedging strategy as mere selling of Options will leave with unlimited risk.

If you believe that there is some positive ‘news’, you might be tempted to buy the Options inspite of high Volatility (or buy the underlying).

Question :What if the Implied Volatility is lower than Historical Volatility?

Answer :This is also possible. It could indicate that the Option itself is being underpriced in the market (which could make it a good buy on its own merit). It could indicate that the market believes that the days of high Volatility in that scrip are over and it will now trade a lower level. Another possibility is that there is some bad news whereby the underlying stock price is expected to move down and the Option has first started reflecting this possibility.

Question :What should I do to fine tune my understanding?

Answer :If you are a serious derivatives market player, you should track historical Volatility very closely. It is recommended that you work out 10 day and 20 day moving Volatilities on a continuous basis. A moving daily trend would be very useful.

Once you have this set of numbers, you could compare with Implied Volatility to arrive at a more definitive conclusion. For example, you could find the following information:

10 day Volatility Today (of last 10 days) : 61%

20 day Volatility Today (of last 20 days) : 57%

Max 10 day Volatility in the last 6 months : 62%

Max 20 day Volatility in the last 6 months : 59%

Implied Volatility Today : 71%

This set of data reveals that the current Implied Volatility is way beyond historical levels and the likelihood of some positive news in the scrip is probable. If you plan to sell the Option on the assumption that it is overpriced, that strategy is dangerous and should be dropped.

On the other hand, if the data shows up as under:

10 day Volatility Today (of last 10 days) : 51%

20 day Volatility Today (of last 20 days) : 47%

Max 10 day Volatility in the last 6 months : 72%

Max 20 day Volatility in the last 6 months : 67%

Implied Volatility Today : 61%

This would indicate the possible overpricing of the Option at current levels, but as the Implied Volatility is within the maximum levels reached in the recent past, there does not appear to be abnormal behaviour in the price. Advanced players could consider selling such Options which have a ‘statistical edge’ and if necessary covering the position with some other Option or Future. Selling such Options needs further discussion, which we will try and explore in later articles in this series.

If you are anyway considering selling the Option (for reasons other than Volatility reasons enumerated here), you could think that this is an appropriate time for selling the Option as the edge will help you in increasing your profit to a small degree.

Question :How much does Volatility affect an Option’s price?

Answer :It does affect the price quite significantly. Some examples are provided below:

Days to expiry : 30 days

Interest Rate : 12% per annum

 At The Money Option :

Stock Price : 260

Strike Price : 260

In the Money Option :

Stock Price : 300

Strike Price : 260

Out of the Money Option:

Stock Price : 240

Strike Price : 260

You can see that the price of the Option is significantly affected in all three types of Options.

Question :What are the Advanced applications of Volatility trading?