This week I would like to continue our discussion of how option pricing takes place with a peek at the most interesting variable of any options pricing model. It is the only variable that can only be measured after the option prices are known. All the other variables have precise mathematical measurements, but volatility has an essentially emotional component that defies easy understanding. If option trading were a poker game, volatility would be the wild card.
I hope you enjoy the discussion.
Understanding Volatility - Part 1
Volatility is the most exciting measure of stock options. Quite simply, volatility means how much you expect the stock to vary in price. It is a little confusing because it may refer to historical volatility (how much the company stock actually fluctuated in the past) or implied volatility (how much the market expects the stock will fluctuate in the future).
When an options trader says "IBM's at 32%" he is referring to the implied volatility of the front-month at-the-money puts and calls. Some people use the term "projected volatility" rather than "implied volatility." They mean the same thing.
A staid old stock like Procter & Gamble would not be expected to vary in price much over the course of a year, and its options would carry a low volatility number. For P & G, this number currently is 27%. That is how much the market expects the stock might vary in price, either up or down, over the course of a year.
Here are some volatility numbers for other popular companies:
IBM - 32%
Microsoft - 37%
Apple Computer - 43%
You can see that the degree of stability of the company is reflected in its volatility number. IBM has been around forever and is a large company that is not expected to fluctuate in price very much, while Apple Computer has exciting new products that might be great successes (or flops) which cause might wide swings in the stock price as news reports or rumors are circulated.
Volatility numbers are typically much lower for Exchange Traded Funds (ETFs) than for individual stocks. Since ETFs are made up of many companies, good (or bad) news about a single company will usually not significantly affect the entire batch of companies in the index.
Here are some volatility numbers for the options of some popular ETFs:
Dow Jones Industrial (Tracking Stock - DIA) - 27%
S&P 500 (Tracking Stock - SPY) - 30%
Nasdaq (Tracking Stock - QQQQ) - 32%
Since all the input variables that determine an option price in the Black-Scholes model (strike price, stock price, time to expiration, interest and dividend rates) can be measured precisely, only volatility is the wild card. It is the most important variable of all.
If implied volatility is high, the option prices are high. If expectations of fluctuation in the company stock are low, implied volatility and option prices are low.
Of course, since only historical volatility can be measured with certainty, and no one knows for sure what the stock will do in the future, implied volatility is where all the fun starts and ends in the option trading game.
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Terry
Continued concerns over the validity of the economic recovery and upcoming second quarter earnings kept most market participants on the sidelines this past week and as a result, the bears took over for the fourth straight week.
Economic reports were mixed for the week. The ISM services index came in better than economists' forecasts at 47%, yet the number is still below 50% which suggests that the services sector is still in the process of contracting.
The initial claims report was a microcosm of the week. The Department of Labor reported that 565,000 filed for jobless benefits, which was the first reading below 600,000 since early January.
"This is not as positive as it looks," Jennifer Lee, an economist at BMO Capital Markets, wrote in a note to clients. "There are a number of special factors at play here, including the fact that the holiday-shortened week skewed the data."
However, economists' believe that the July 4th holiday altered the number a bit. In my opinion, it doesn't really matter because people are still losing jobs at a rapid rate. Continuing claims reached a record level of 6.8 million at the end of June and we still keep adding more and more losses to the record levels.
"Job insecurity is crushing confidence in consumer spending," said John Skjervem, chief investment officer for Northern Trust's Personal Financial Services. "There is not a lot of good news to hang on to."
Consumer sentiment, as provided by the University of Michigan, fell once again and this time to its lowest levels since early March. Consumers' rising concerns about a protracted economic downturn, job security and erosion of wealth were the main factors depressing sentiment, the survey said.
The report came in at 64.6, well below economists' forecast for 70.5. It was also the fist decline since February.
"It underlines the ongoing gloom facing the U.S. consumer and further delays prospects for a near-term recovery. That will weigh heavily on risk sentiment," said Brian Dolan, senior currency strategist with Forex.com in Bedminster, New Jersey.
"Consumers concluded that the economic downturn would last longer and their personal finances would not recover as quickly as they had previously expected," the Reuters/University of Michigan Surveys of Consumers said in a statement.
There is no doubt that the market has been in a lull since the beginning of May. Sell in May and go away? On Friday the S&P closed less than two points away from the closing price on May 1st. However, given the upcoming earnings season we should see quite a bit of action over the next few weeks. As I stated back in early May, my guess is that we will continue to stay within a range during the summer doldrums. Now that we are back towards the bottom part of the range with the major market benchmarks in an oversold state I would expect to see a nice bounce coming our way over the next week or so.
Overbought/Oversold as of July 10, 2009
Major Benchmarks