Volatility

Introduction 1 of 4
It's a given in the marketplace that a stock will vary in price throughout the trading day. With each successive
trade, the price can go up or down, or remain unchanged.
If you review a stock's daily closing prices over a period of time, you can observe these net changes, also
called returns. These changing, or fluctuating, trading prices represent a stock's volatility. Volatility doesn't
represent a bias for up or down price movement, but just fluctuation over a period of time. 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.

Looking at the price

As a derivative security, an equity option's value is determined largely by its underlying stock price. So when
you value an option on any given day, the current stock price is crucial. But so is the expected stock
price behavior over the lifetime of the option - specifically where the stock could be trading before and at
expiration.
When they use an option pricing model, such as the well known Black-Scholes model, to price calls and puts,
investors and option professionals alike rely on the stock's volatility factor to assess what those prices might be.

Volatility, High vs Low

Introduction 2 of 4
For investors pricing a specific option, most pricing model input is observable, or evident, andfairly uniform. In
other words, everybody pricing an XYZ June 50 call today with the underlying at $50 will be using:

50 for both the strike and underlying price

The same number of days until expiration

The same dividend information with respect to amount and timing

The interest rate they use may differ a bit, but this factor generally has little impact on an option's market price.
Most investors use a current risk-free rate, such as the current T-bill rate.

What you can't see

Volatility, however, is another matter. It's not directly observable. An investor pricing an option, or calculating
its theoretical value, can either assume that an underlying stock's past history of price fluctuation will repeat
itself, or assume that it will either increase or decrease, and by how much.
In other words, because pricing an equity option calls for a forecast of the underlying stock's performance over
the option's lifetime, any volatility assumption is ultimately subjective. But at the same time, apart from
underlying stock price, the volatility factor has perhaps the most significant effect on an equity option's market
price.

The key factors

The factors that affect the price of any equity option, and are the input for most option pricing models, include:

Underlying stock price

Volatility

Strike price

Time until expiration

Interest rate

Dividends

Introduction 3 of 4
How does changing underlying stock volatility affect the prices of equity options? Call and put buyers will pay
more for higher volatility because more price fluctuation is theoretically possible, increasing the probability that
the underlying will perform very well or very poorly. This increases the potential degree of profit for a long call if
the stock performs well, or for a long put position if the stock performs poorly.

A risk premium

Call or put writers, on the other hand, expect to receive more money because more underlying stock price
fluctuation carries more risk. A call writer has assumed a bearish position. A higher underlying stock volatility
infers a greater chance that the stock might do very well over the lifetime of the contract, and assignment is
more likely with a higher stock price. A bullish put writer incurs more risk from increasing volatility for the opposite
reason. Assignment is more likely from a lower stock price.
Following this logic, a rule about volatility in the option marketplace is that all other option pricing factors
remaining the same:

Degree of change
In comparing two stocks' volatility over a given period of time, it's not the beginning and ending prices that are
significant, but instead it is the fluctuation between these points.

Introduction 4 of 4
This class is only an introduction to the mathematical concept of volatility. It covers how volatility is
measured, what that measure can represent, and how you might begin to consider volatility when
you're making option investment decisions.
The nuts and bolts of the probability theory involved in volatility calculations, and the dos and
don'ts about trading fluctuating volatility levels, are far beyond its scope. Predicting volatility can be
risky business and is generally left to market professionals who devote time and resources to
studying this phenomenon.
After this class, however, you should have a clearer understanding of the relevance of volatility, as
well as its potential financial impact on your options positions. Ultimately it affects the price you pay
or receive for an option in the marketplace.

Taking the next step

Check out the numerous books and seminars on the
subject of volatility that are available, as well advisory
services that offer informed opinions about where the
volatility of an individual stock, the broad market, or a
market sector might be going.

What Is Volatility 1 of 7
To an options trader, volatility is a measurement of an underlying stock's fluctuation in price, past or future. It's
usually expressed as a percentage, and that number is used with a pricing model to calculate an
option's current theoretical value.
Say you're looking at stock XYZ's trading history over the last year. At the beginning of this period, or one year
ago, the stock's closing price might have been $50. The next trading day the stock closed up $0.25, or at $50.25.
This increase of $.0.25 represents a return of +0.5% over the previous day's closing price of $50 ($0.25 $50 =
+0.5%). The next day, XYZ closed down $0.10, or at $50.15, for a -0.2% return over the previous day's $50.25
close ($0.10 $50.25 = -0.2%). And you can reasonably anticipate that some change will occur the next day and
the days after that.

The bigger picture

Because observations of closing prices and returns of XYZ are made and recorded for each trading day of the
year, a statistician can determine a measure of XYZ's historical volatility for this period. Simplified, the volatility
will be calculated as the stock's annualized standard deviation of returns, and expressed as a percentage.

Standard deviation
Standard deviation is a statistical measure of the degree to which an individual value, such as a stock price, is
likely to vary from the mean, or average, of all the values in the sample. In the case of a stock price, the greater
the probable variance, the greater the volatility.

What is Volatility 2 of 7
Once a volatility percentage has been calculated using historical data, you can use statistical tables to
determine the number of times a stock's closing price has fallen within given price ranges. As a rule of thumb,
options investors can assume that:
At the end of the period in question (usually 1 year), an underlying stock's closing price has been within:

1 standard deviation about 2/3 of the time (about 68%)

2 standard deviations about 19/20 of the time (about 95%)

Inversely, at the end of the period in question the underlying has been outside(either above or below) a range of:

1 standard deviation 1/3 of the time (about 32%)

2 standard deviations 1/20 of the time (about 5%)

Based on the observed daily closing prices and returns for the hypothetical stock, XYZ, assume that its historical
volatility has been determined to be 20% on an annual basis. What specifically can this number reflect about the
stock's price fluctuation over the last year?
Rule of thumb

If you know a stock's historical volatility, you can assume how often it is likely to close within a given price range.

Within 1 standard deviation

Within 2 standard deviation
Outside 1 standard deviation
Outside 2 standard deviation

What is Volatility 3 of 7
For the past year, records show that the price of XYZ closed most often at $50, where it is trading again now.
Increasingly higher or lower closing prices occurred less frequently. So what do you discover if you apply XYZs
calculated volatility of20% to the rule of thumb about price range?
At end of the period in question (1 year) an underlying stock's closing price has been within:

1 standard deviation of 20% about 2/3 of the time

In other words, XYZ closed within a range of 20% up or down from $50, or between$40 (down 20 % or $10)
and $60 (up 20% or $10), 2/3 of the time.
Only 1/3 of the time did XYZ close outside this range. And on those occasions, it has been within:

2 standard deviations of 40% 19/20 of the time.

In other words, XYZ closed within a range of 40% up or down from $50, or between$30 (down 40 % or $20)
and $70 (up 40% or $20), 19/20 of the time. Only 1/20 of the time did XYZ close outside this range.
Assuming a trading range
If a stock has closed at or around $50 a share for most of the year, what can you assume about its probable
trading range?
Within/outside 1 standard deviation
Within/outside 2 standard deviation

What is Volatility 4 of 7
Now you can compare the previous example of XYZ with historical volatility of 20% to another stock, ZYX, with a
calculated historical volatility of 40%. Again, you can use the same rule of thumb:
At the end of the period in question (1 year) its closing price has been within:

1 standard deviation of 40% about 2/3 of the time

In other words, ZYX closed within a range of 40% up or down from $50, or between$30 (down 40 % or $20)
and $70 (up 40% or $20), 2/3 of the time. Only 1/3 of the time did XYZ close outside this range.
And on those occasions, it has been within:

2 standard deviations of 80% 19/20 of the time

In other words, ZYX closed within a range of 80% up or down from $50, or between$10 (down 80% or $40)
and $90 (up 80% or $40), 19/20 of the time. Only 1/20 of the time did ZYX close outside this range.
Note that the higher the volatility percentage, the wider the range of trading prices.
Wider price ranges
With greater volatility, the spread in the dollar amount
at which a stock may close widens, but the likelihood
of exceeding predictable trading ranges does not.
Within/outside 1 standard deviation
Within/outside 2 standard deviation

What is Volatility 5 of 7
At this point it's worth repeating a concept about volatility that was introduced earlier. A stock's volatility reflects
its price fluctuations, either up or down, and does not imply a bias for overall price trend, bullish or bearish. In
other words, the hypothetical stock XYZ was, during the last year, just as likely to have closed below its most
common price of $50 as above this amount.

Variation is the rule

Within any period in the past, a stock's volatility could have varied during different specific time frames. For
instance, XYZ's closing prices were observed for the last year. Within a given month in that period, its volatility
could have been greater or smaller than during any of the other 11 months. Further, because its volatility for the
last year was measured as 20% does not necessarily imply that next year its volatility will remain the same.
Most often, the volatility numbers used to value options with a pricing model reflect a year's worth of observed
closing price data. However, volatility measurements may be calculated using observed closing prices over a
period of either less or more than the past year. These measurements are usually then annualized.

What Is Volatility 6 of 7
If you investigate historical volatilities on a stock from whatever source, note that they
are recalculated periodically. An annualized historical volatility measured today will not necessarily be the
same as one calculated a month from now. Today's calculation reflects the past 12 months of trading activity. A
calculation made a month from now using the past 12 month's trading prices will include figures from next month
and drop those from the oldest month in the current calculation. And the stock in the next month can become
much more or less volatile, affecting the result of that calculation.

Finding the data

You can obtain historical volatility numbers from a variety of sources. Check with your brokerage firm. These
volatilities may be found on its website. Check also with 888-OPTIONS for various sources of historical volatility
information on stocks underlying their listed equity options. In addition, there are numerous online stock quote
vendors, newsletters, and trading advisory services available, sometimes for a fee.

What is Volatility 7 of 7
What kinds of things can result in changing stock volatility? They include factors such as:

Fundamental changes in a company's balance sheet

Uncertain future earnings projections

Economic factors affecting the overall market or a stock's particular market sector, e.g.,
pharmaceutical or retail

A company's move into uncharted waters, such as a more speculative business

Changing market psychology, as in concern or lack thereof of political or military situations possibly
arising

Stock splits can have an effect on volatility as well. Generally speaking, splits have a tendency to decrease
stock volatility, while mere anticipation of a possible split can increase it.

Past vs. Future 1 of 10

You've learned that a volatility percentage that's been calculated based on a stock's actual past trading history
reflects a range of closing prices over a given time period, usually one year. This is known as an
annualized historical volatility. However, 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.

Using theoretical values

Any option pricing model will require a volatility number, usually annualized, as input for calculating an
option's theoretical value. As any volatility assumption is ultimately a subjective one, what value do you use?
Unfortunately, the answer to this is not a firm one. Anybody else's volatility assumption is by nature as subjective
as yours.
If you do have a firm estimation about an underlying stock's future volatility level, you can use this measure in a
pricing model to compare its current market price to its theoretical value. Any difference between the two will
be your relative gauge of how overpricedor underpriced that option may be.

Past vs. Future 2 of 10

If you have no opinion about the variance between an underlying stock's past and possible future trading
patterns, using historical volatility might be as good a place to start as any. This historical volatility then
becomes yourforecast volatility, and you are assuming that the underlying stock's future volatility will remain
relatively constant compared to its trading history.

Uncertain answers

But will history repeat itself? Some stocks do trade within a given price range, or at a consistent volatility level,
for extended periods of time, whereas other stocks' volatility levels can be observed to change in a predictable
pattern, perhaps even seasonally.

Whether you use an historical volatility or one of your own to calculate atheoretical value, you will frequently find
an option priced in the marketplace above or below your expectation. When this is the case, the marketplace is
collectively making a volatility assumption different from yours. This is calledimplied volatility.

Past vs. Future 3 of 10

Implied volatility is that volatility measurement that produces
an option's actual market price as its theoretical value. 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. Sometimes these changes can be significant and
abrupt, short lived or longer term.

What the numbers imply

To determine an option's implied volatility you can use an options pricing calculator. You enter all
known pricing factors, as well as a volatility amount that may be an historical measurement or one of your own,
and then calculate a theoretical value. If this value differs from current market price, adjust the volatility
factor up or down accordingly until the theoretical value matches the option's actual price in the marketplace.
This will be the implied volatility.
Alternatively, some pricing calculators offer specific functionality for calculating implied volatilities more directly.
There's a calculator designed for easy calculation of implied volatilities in the next chapter. It is also accessible on
the menu below.

Past vs Future 4 of 10
Implied volatility can be considered for a class of options as well as for a specific call or put contract. In other
words, you might wish to determine an overall implied volatility for calls, puts, or both on XYZ stock as opposed
to only an XYZ June 50 call.

To do this, you can calculate implied volatilities for options that are typically more fairly priced in the
marketplace, such as those currently closer to the current underlying stock price, those with the largest recent
trading volume, or both. After finding those numbers, you can average the amounts.

Refining the rule

Bearing in mind the fact that implied volatility levels can fluctuate, you can modify the rule about the effect of
changing volatility on the prices of both calls and puts:

A 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.

Past vs. Future 5 of 10

What kinds of things can affect implied volatility? Shifting supply and demand, or an imbalance in buyers
versus sellers in the marketplace, is a principal one. As with any security, more buyers will generally increase the
price, more sellers will usually decrease the price.

Putting on the pressure

This pressure on prices may be gauged by changing implied volatility levels, and can be seen with or without a
move in the underlying stock's price. The effect can be seen on one particularoption series, like XYZ May 50
calls and puts, or the whole class, as in all XYZ options.
Take over rumors can definitely impact implied volatility. If an underlying stock is the target of a buy out, this is
generally a bullish influence on its price, so buyers can flood the option market for calls. Increasing call prices
will result in increasing put prices, and produce an increase in the option's implied volatility.

Pressure points
What factors may influence implied volatility levels of options on any given stock?

Supply & demand in the options market

Take over rumors

Changes in underlying stock volatility

Large revision in a company's earnings estimates

Uncertain financial fundamentals of the underlying company

Uncertain market sentimentin the broad market

Past vs. Future 6 of 10

Changing volatility of an underlying stock may or may not be reflected in changing implied volatility of its
options. If the stock's change in volatility, up or down, is significant, then implied volatility usually follows suit. This
depends on concern or anticipation in the marketplace about the stock's future price range.
In general, any factor that suggests uncertainty on a stock's future price performance can increase the implied
volatility of its calls and puts. On the other hand, factors that can result in stability such as little price
movement, or steady and consistent bullish or bearish trends can lower implied volatility.

Past vs. Future 7 of 10

Whether you have no volatility opinion and buy or sell an option at a current implied volatility level, or wait and
make your transaction at a specific level, in either case you're accepting a theoretical distribution of future
underlying stock prices predicted by that volatility. This distribution can be predicted with the same formula that
was employed to calculate historical volatility using past stock prices.
Remember the rule of thumb about historical volatility measurements and observed stock price distributions. At
the end of the period in question (usually one year) an underlying stock's closing price has been within:

1 standard deviation about 2/3 of the time (about 68%)

2 standard deviations about 19/20 of the time (about 95%)

Inversely, at end of the period in question the underlying has been outside either above or below a range
of:

1 standard deviation 1/3 of the time (about 32%)

2 standard deviations 1/20 of the time (about 5%)

Predicting prices
To anticipate future stock prices, you can use the same rule of thumb about trading ranges that applies to
historical volatility.
Within 1 standard deviation
Within 2 standard deviation
Outside 1 standard deviation
Outside 2 standard deviation

Past vs. Future 8 of 10

Now apply this rule of thumb to the future. For instance, suppose you're buying or selling an XYZ call at a 25%
volatility, which represents an annualized standard deviation of 25%. This means you're accepting various price
ranges with statistical probabilities.
Say XYZ stock is $60 when you purchase or sell the call at this 25% volatility level. You might expect:
At end of one year, XYZ's closing prices to have been within:

1 standard deviation of 25% about 2/3 of the time

In other words, XYZ might trade within a range of 25% up or down from $60, or between $45 and $75, 2/3 of the
time. Inversely, the probability that XYZ will close outside this range is only 1/3, or about 32%.
In addition, you might expect the stock's closing price to be within:

2 standard deviations of 50% 19/20 of the time

In other words, XYZ might trade within a range of 50% up or down from $60, or between $30 and $90, 19/20 of
the time. Inversely, the probability that XYZ will close outside this range is only 1/20, or 5%.

Assuming a trading range

If you purchase a call on a stock trading at $60 with a 25% volatility level, what assumptions can you make about
its trading range?
Within/outside 1 standard deviation
Within/outside 2 standard deviation

Past vs. Future 9 of 10

The previous calculations assume you're using an annualized volatility number. But what if a
call or put expires before a year's time? The formula may be adjusted to reflect theoretical
trading ranges for a specific unit of time, say a week or a month. To find that number, divide the
standard deviation percentage - the volatility, either implied or your own - by the square root of
the number of those time units in a year.
For example, suppose you buy an XYZ call or put at an annualized volatility of 25%, with XYZ
stock currently at $60, but with the contract expiring in one month when there are 12 months in
the year. Here's the formula

According to our formula, for the next month you can expect XYZ to have a trading range of :

1 standard deviation of $4.33 about 2/3 of the time

In other words, XYZ might trade within a range of $4.33 up or down from $60, or
between$55.67 and $64.33, 2/3 of the time. Inversely, the probability is that XYZ will close
outside this range only 1/3 of the time.
Again, any calculation of expected trading range considering volatility is strictly theoretical. An
underlying stock, of course, may or may not perform as expected.

When it's less than a year

This is the formula for calculating volatility expectations of less than one year:

Past vs. Future 10 of 10

In the discussion here about what volatility represents or quantifies, the theoretical statistics involved have been
considered only briefly. A more thorough, comprehensive coverage of the math behind volatility, both its
derivation and application, is beyond the scope of this class.

Taking the next steps

If it's your intention to trade volatility, or to focus primarily on volatility when making your options investment
decisions, then a more comprehensive grasp of the subject might be in order. There are books available devoted
solely to option volatility and all of its ramifications. As well, you might look for a seminar, a newsletter, or an
adviser for guidance.
Even the most superficial understanding of volatility theory, however, can be helpful in trading options.
Awareness of implied volatility levels, how and why they change, and how they can affect the value of your
positions can help reduce surprises from unexpected option price behavior in the marketplace. Beyond the
theoretical issues, you'll want to take a look at practical aspects of volatility and your options positions.

Effect on Pocketbook 1 of 7
The effect that changing volatility levels have on an option's price in the marketplace is on the time value portion
of its premium. That is the amount of premium in excess of the option's intrinsic value, if it has any.
During its lifetime an option that is exactly at or out-of-the-money has no intrinsic value, so itspremium is
entirely time value. At expiration, however, an option is worth only its intrinsic value. All time value at this point
has eroded away, and profitability is determined by whether or not the option is in-the-money and has any
intrinsic value.

Changing the rate of time decay

Changing implied volatility levels during an option's lifetime can either enhance or decrease the effect of time
decay. For any one option contract, assuming that the underlying stock does not change significantly in price
over a period of time, increasing implied volatility may offset the theoretical rate of time decay and keep its
market price higher than expected. A declining implied volatility level for the same option, on the other hand,
might augment the effect of time decay and result in a market price that is lower than theoretically expected.

Effect on Pocketbook 1 of 7
The effect that changing volatility levels have on an option's price in the marketplace is on the time value portion
of its premium. That is the amount of premium in excess of the option's intrinsic value, if it has any.
During its lifetime an option that is exactly at or out-of-the-money has no intrinsic value, so itspremium is
entirely time value. At expiration, however, an option is worth only its intrinsic value. All time value at this point
has eroded away, and profitability is determined by whether or not the option is in-the-money and has any
intrinsic value.

Changing the rate of time decay

Changing implied volatility levels during an option's lifetime can either enhance or decrease the effect of time
decay. For any one option contract, assuming that the underlying stock does not change significantly in price
over a period of time, increasing implied volatility may offset the theoretical rate of time decay and keep its
market price higher than expected. A declining implied volatility level for the same option, on the other hand,
might augment the effect of time decay and result in a market price that is lower than theoretically expected.

A plus or a minus?
Is changing volatility good or bad for you? This depends on whether youre long or short options. In general, for
more profit potential before expiration, while an option still has time value:

Long positions you want increasing volatility

Short positions you want decreasing volatility

Effect on Pocketbook 2 of 7
First, consider a hypothetical scenario for a long 60 call. With 90 days to expiration and a volatility assumption
of 35% it might be worth approximately $4.50. After the passage of 30 days, or with only 60 days to expiration,
assume there is no change in underlying stock price, dividend or interest rate, and that the implied volatility
remains constant at 35%. In this case the call's theoretical value might be around $3.60, with time decay
reducing its value by 90.

Rising volatility/reducing decay

Now assume after 30 days there is still no change in stock price, dividend, or interest rate, but that the call's
implied volatility has risenby approximately 10% to a level of 39%. In this case the call's theoretical value might
be around $4.00. This increase in volatility has reduced the expected time decay from 90 to 50, and the call's
theoretical value is greater than the value of $3.60 expected with no change in volatility. This is a positive
scenario since you're long the call and want its value to increase. If you were short this option, this change in
volatility would not be so positive.

Effect on Pocketbook 3 of 7
Included on the menu bar below is a volatility calculator that will allow easy calculation of implied volatility for
listed equity options. Click to open the calculator, and take a look.
Step one: On the left of the calculator fill in the input values for your underlying stock's current price and dividend

information, the current risk-free interest rate, and select the appropriate expiration cycle. You can leave the
volatility input blank because you're going to determine an option's implied volatility. Today's date is already
provided.
Step two: On the right side of the calculator, fill in your call or put's strike price, current market price (premium),

and select the expiration month. Click on "Calculate" to determine the option's current implied volatility. This
volatility level is the consensus of the marketplace today on the underlying stock's volatility from now until
expiration, as implied by the option's current market price.
Implied volatility does change, sometimes unexpectedly, abruptly, and by significant amounts. At any point in its
lifetime, if your option's market value seems higher or lower than you expect, then check its implied volatility. A
change in this measurement might account for the difference.

http://www.optioneducation.net/calculator/pu_volatility.asp

Effect on Pocketbook 4 of 7
Some investors study implied volatility levels and choose options strategies accordingly. Knowing past implied
volatility levels for options on any underlying stock, they note whether current levels are higher or lower than they
have been.

Assessing values, choosing strategies

If implied volatility levels are lower than usual that is, the options appear relatively undervalued these
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, they 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.

Making a forecast

These investors are usually familiar with the phenomenon of changing implied volatility levels and are confident in
their opinions about what these levels will be over the lifetime of their positions. They are forecasting volatility
behavior. As informed as their decisions may be, however, buying undervalued options and selling
overvalued options will not by any means guarantee profit if implied volatility returns to historical levels.

Effect on Pocketbook 5 of 7
When you're thinking about buying or selling an option, but don't have an opinion about the underlying
stock's future volatility, or that's not a factor in your investment decision, you might still be aware of the current
level of implied volatility. It can affect the profitability of your positions.
When you buy a call or put, the more you pay, the greater the effect on your break-even point at expiration. For
a call, higher premium results in a break-even point at a higher underlying stock price. For a put, the more you
pay for the option, the lower the underlying stock price you need to break even at expiration.

Anticipating the unexpected

Investors who aren't focused on volatility are frequently motivated by an overriding opinion about an underlying
stock's price and an option's intrinsic value at expiration. Before expiration, however, changing implied
volatility may result in unexpected, early, unrealized profits or losses.
When changing volatility works in your favor, whether or not the underlying stock price has moved as you
expected, you might see anunrealized gain. This profit may be realized by closing out the position in the
marketplace. If implied volatility moves against you, though, and unrealized losses mount, you might feel
pressured to take a loss early, despite your prediction of the underlying stock price at expiration.

Effect on Pocketbook 6 of 7
Take a look at an extreme, hypothetical example to see how an unexpected and abrupt change in implied
volatility could occur. Say you own an XYZ 60 call. The stock closed yesterday at $60, and your call was at
$4.00 with an implied volatility of approximately 25%.

The effect of the unexpected

Today, shortly after the market opened, XYZ Corporation made the unexpected announcement that it's
reorganizing its corporate structure. The marketplace is uncertain of the impact on future earnings, so the stock
traded in an unusually wide range for the rest of the day. As the market closed, XYZ stock's price had settled
back to its previous day's close of $60, but your call last traded for $4.25, up $0.25.

Benefiting from volatility

There's been no net change in closing underlying stock price, dividend, or interest rate, and you might have
expected your call price to actually decrease slightly due to time decay. So how do you explain this increase? It
can be attributed to a rise in the call's implied volatility due to increased uncertainty in the market about the
future price of the underlying stock.

Effect on Pocketbook 7 of 7
More typical examples of the effects of changing implied volatility on your profit and loss (P&L) might work like
the following examples. When XYZ stock was trading for $60, suppose you bought an XYZ 60 call expiring in 90
days for $4.00, or at a 30% implied volatility. Your target price for XYZ at expiration was in the $67 to $68
range.

Implications for price

After one month, XYZ has risen to $63. Based on a pricing model, you expected your 60 call's theoretical
value in this scenario to be $5.00 at the same 30% implied volatility. However, with no interim change in interest
rate or dividend, and even though the stock price is increasing, you find your call trading for $4.60 - a profit over
its purchase price but less than expected. The implied volatility of this call has dropped from 30% to 25%. If the
implied volatility had dropped to 15% at this point you might have found your call trading for $3.75, or at
an unrealized loss compared to its $4.00 purchase price.
On the other hand, if the stock is at $63 and there has been an increase in implied volatility from 30% to 40%,
you might find your call trading for $6.00 as opposed to the expected price of $5.00.

Conclusion 1 of 2
Here are some important points to remember about volatility:

Volatility represents underlying stock price fluctuation, not price trend.

It can be measured as the annualized standard deviation or returns.

Implied volatility represents a market consensus on a stock's future volatility.

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.

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.

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. As well, you
might develop a more comprehensive understanding of the mathematics (particularly probability theory) involved
than is covered in this class.

Conclusion 2 of 2
Trading implied volatility means focusing primarily on a favorable change in an option's volatility level to achieve
a profit. For most individual investors, however, seeing their opinion on an underlying stock price trend, bullish,
bearish or neutral, actually fulfilled is just as important, and can lead to profit despite implied volatility behavior
before expiration.
So when you establish an options 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. They can be
two distinctly different phenomena.
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.