Hello blog readers,
Since my project is literally about finding and discussing differences between implied and historical volatility in various sectors, I believe it is important to learn about option valuation first. Therefore, this week, I spent my time reading option evaluation by Investopedia.
Intrinsic value, time to expiration (or time value), volatility, interest rates and cash dividends are all factors in valuing an option. Volatility is arguably the most important. Remember volatility (historical) is just the standard deviation of the stock. Therefore, higher volatility just means the stock jumps around and spikes up and down more than another stock with less volatility. You might find it easier to think of volatility as a general benchmark of risk (stocks that jump around more are riskier). An option contract listed for a stock with higher volatility will generally have a larger premium because there is there is a greater probability the stock can move in either direction. To understand this, you must have basic understanding of what an option is and some logical intuition.
Investopedia explains this better:
“An option’s time value is also highly dependent on the volatility that the market expects the stock will display up to expiration. For stocks where the market does not expect the stock to move much, the option’s time value will be relatively low. The opposite is true for more volatile stocks or those with a high beta (don’t worry about what beta is), due primarily to the uncertainty of the price of the stock before the option expires. In the table below, you can see the GE example that has already been discussed. It shows the trading price of GE, several strike prices, and the intrinsic and time values for the call and put options.
General Electric is considered a stock with low volatility with a beta of 0.49 for this example.
Amazon.com Inc. (AMZN) is a much more volatile stock with a beta
of 3.47. Compare the GE 35 call option with nine months to expiration to the AMZN 40 call option with nine months to expiration. GE has only $0.20 to move up before it is at the money, while AMZN has $1.30 to move up before it is at the money. The time value of these options is $3.70 for GE and $7.50 for AMZN, indicating a significant premium on the AMZN option due to the volatile nature of the AMZN stock.”
Now that we covered historical volatility and what role it plays in valuing an option, we must also talk about implied volatility. When I reverse the Black-Scholes equation to find volatility, it will spit out implied volatility because I am feeding it current option prices. Logically then, implied volatility is current volatility. The reason this is important to differentiate is because how volatile a company was 5 years ago is not how volatile it is now. This is why many banks are investing in new formulas which won’t make the mistake of using historical volatility (I want to see if this is worth it). Conclusively, the difference between implied and historical volatility are large enough to matter which just re-enforces why I believe it is important to conduct my project.