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If you’re like most options traders, you already understand the implied volatility of an option is a measure of how much the markets expect the underlying to move over the life of the option. You also probably know that options that trade at high implied volatilities are more expensive relative to options that trade at lower implied volatilities when everything else is equal.
For instance, let’s look at a hypothetical stock trading at $100/share. The at-the-money, 100 strike call with 60 days remaining to expiration would be worth $3.30 when priced at 20% implied vol. (20% is just above the level that the VIX has been trading lately and about what you’d expect for a typical large-cap stock.)
If you take that same option ($100 stock, 100 strike, 60 days to expiration) and raise the volatility input to 50%, it will now be worth $8.15. That’s a pretty big difference! If you thought that stock had some upside potential in the next two months and you wanted to take a long position in an at-the-money call to capitalize on that movement with limited risk, those options are very different.
With the higher vol option, not only does the stock have to move up $8.15/share before you break even (instead of just $3.30), but if you’re wrong and the stock sits still or declines between now and expiration, you lose more than twice as much on the premium you spent on that ultimately worthless option.
That volatility input is a representation of how much the market expects the underlying to move over the course of a year. Even if it’s an option that has less than a year remaining – and most traded options do – the vol is expressed as an annual percentage. Assuming that stock returns can be described by a normal distribution, the volatility input to the pricing model is the size of an expected one standard deviation move over the next year.
Options traders sometimes describe the level of implied vol not in terms of a percentage, but in terms of the price of the “straddle” the combination of an at-the-money call and put. As in, “the 60-day straddle is trading $16.30." It’s a measure of how much the market expects the stock to move over that specific period - in this case, $16.30 in either direction.
When stocks are moving quickly, implied vols can go up in a hurry – sometimes well into the triple digits. Our theoretical 100 strike, 60-day call on a $100 stock priced at 250% vol is worth $39. Due to the principle of call/put parity, that means the 100 strike put is also worth about $39 and the straddle is worth $78.
If you bought it, the shares would have to go below $22 or above $178 before you made a cent. At every price in between, you would lose money. That doesn’t sound like a very good trade, does it? Stocks do occasionally move that much in 60 days, but it’s extremely rare.
As an even more stark example of what that 250% volatility means, let’s shift it out the expiration date.
A 100 strike call option a $100 stock with 120 days until expiration priced at 250% vol is worth $52.75. So is the 100 put. That means the straddle is worth about $105.
(You might intuitively think that a put can’t trade for more than than its strike price, but because of call/put parity, it absolutely can.)
Make no mistake, this means that in no scenario can buying that straddle result in a profit if the stock falls, because the shares can only go to zero and not below. And the stock would have to more than double for the trade to simply break even.
Those super-high implied vols are less common in longer dated options, but they do happen.
They’re much more common in shorter term options - like we saw this week in Robinhood (HOOD - Free Report) . If you’re the buyer, you should understand that you have to be exactly correct about the direction, timing, and magnitude of the move to make any money. The odds are not on your side.
-Dave
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What does 250% implied volatility really mean?
If you’re like most options traders, you already understand the implied volatility of an option is a measure of how much the markets expect the underlying to move over the life of the option. You also probably know that options that trade at high implied volatilities are more expensive relative to options that trade at lower implied volatilities when everything else is equal.
For instance, let’s look at a hypothetical stock trading at $100/share. The at-the-money, 100 strike call with 60 days remaining to expiration would be worth $3.30 when priced at 20% implied vol. (20% is just above the level that the VIX has been trading lately and about what you’d expect for a typical large-cap stock.)
If you take that same option ($100 stock, 100 strike, 60 days to expiration) and raise the volatility input to 50%, it will now be worth $8.15. That’s a pretty big difference! If you thought that stock had some upside potential in the next two months and you wanted to take a long position in an at-the-money call to capitalize on that movement with limited risk, those options are very different.
With the higher vol option, not only does the stock have to move up $8.15/share before you break even (instead of just $3.30), but if you’re wrong and the stock sits still or declines between now and expiration, you lose more than twice as much on the premium you spent on that ultimately worthless option.
That volatility input is a representation of how much the market expects the underlying to move over the course of a year. Even if it’s an option that has less than a year remaining – and most traded options do – the vol is expressed as an annual percentage. Assuming that stock returns can be described by a normal distribution, the volatility input to the pricing model is the size of an expected one standard deviation move over the next year.
Options traders sometimes describe the level of implied vol not in terms of a percentage, but in terms of the price of the “straddle” the combination of an at-the-money call and put. As in, “the 60-day straddle is trading $16.30." It’s a measure of how much the market expects the stock to move over that specific period - in this case, $16.30 in either direction.
When stocks are moving quickly, implied vols can go up in a hurry – sometimes well into the triple digits. Our theoretical 100 strike, 60-day call on a $100 stock priced at 250% vol is worth $39. Due to the principle of call/put parity, that means the 100 strike put is also worth about $39 and the straddle is worth $78.
If you bought it, the shares would have to go below $22 or above $178 before you made a cent. At every price in between, you would lose money. That doesn’t sound like a very good trade, does it? Stocks do occasionally move that much in 60 days, but it’s extremely rare.
As an even more stark example of what that 250% volatility means, let’s shift it out the expiration date.
A 100 strike call option a $100 stock with 120 days until expiration priced at 250% vol is worth $52.75. So is the 100 put. That means the straddle is worth about $105.
(You might intuitively think that a put can’t trade for more than than its strike price, but because of call/put parity, it absolutely can.)
Make no mistake, this means that in no scenario can buying that straddle result in a profit if the stock falls, because the shares can only go to zero and not below. And the stock would have to more than double for the trade to simply break even.
Those super-high implied vols are less common in longer dated options, but they do happen.
They’re much more common in shorter term options - like we saw this week in Robinhood (HOOD - Free Report) . If you’re the buyer, you should understand that you have to be exactly correct about the direction, timing, and magnitude of the move to make any money. The odds are not on your side.
-Dave