the business is mind-boggling, what with its use of Greek alphabetics like delta and gamma, it’s not always about speculation. In fact, options are often used to reduce the risk of holding investment positions. Options are, in this sense, a form of insurance.
There’s more than just a casual conceptual connection between options and insurance. In fact, your home and auto insurance policies are priced in the same manner as option market makers set their premiums.
Can’t see the connection? Just think about the similarities between options and insurance:
- Term – Each contract provides a benefit to the holder only for a specified time period;
- Strike Price – A home or auto policy effectively grants the owner the right to “put” the subject property to the insurer at a specific price in the event of a total loss, just as a put option affords its holder the right to sell the underlying asset to the grantor at a predetermined exercise price;
- Premium – To obtain each contract’s benefits, the holder must pay a risk-based fee to the seller.
It’s setting that risk-based premium that involves all “the Greeks,” as those parameters are known on the trading floor. Among the most important of the first-order metrics is vega (which, oddly enough, isn’t a Greek letter at all). Vega is a measure of volatility, representing the dollar-per-shift in an option’s value, as expected for each 1 percent change in the underlying asset’s variance.
Too arcane? Let’s look at a practical example to clarify things.
Right now, with the underlying Market Vectors Agribusiness Fund (NYSE Arca: MOO) trading at $39.42, November $40 calls are offered at $1.40 per share. If you dissect the premium with an options pricing model, you’d find embedded in that offer an assumption of annualized volatility—otherwise known as implied volatility—of 32.5 percent. Simply put, that’s the degree to which the fund’s share prices are expected to vary around their mean over the call’s remaining life.
This volatility assumption translates to a vega coefficient of 0.05, which means that, holding everything else constant, you’d expect the call premium to increase by a nickel a share if the fund’s price volatility increases by 1 percent (and to likewise decrease $0.05 if the volatility drops the same amount).
So if the market maker expects the standard deviation in MOO’s daily returns to be 33.5 percent, you’d likely see the offer raised to $1.45 a share. Conversely, an expected risk of 31.5 percent would engender a $1.35 asking price.
At this point, you may be saying to yourself, “So what? I don’t want to trade options.” Well, that may indeed be the case, but it doesn’t mean you can’t make some friends in the options market. Sometimes, market makers can be a stock or fund trader’s best buddy.
To fully appreciate this camaraderie, you need to make a distinction between implied volatility and historic, or statistical, volatility.
As explained above, implied volatility is the expected price variance in the underlying asset, but historic volatility is the actual price variance of the option’s underlying asset over a given period of time—say, 20, 50 or 100 days. If we’re analyzing the November options, which expire in 39 days, we’re most interested in the 50-day historic volatility of MOO, since the option’s life would fit within the statistic’s span.
If you’ve got access to options pricing software and Excel spreadsheets, you can compare historic volatility vs. implied in option premiums, and pinpoint the market maker’s risk expectations. Generally speaking, if there is enough trading interest in a given option that’s close to the money—that is, one with an exercise price close to the underlying asset’s current market price—implied volatility should be fairly close to historic volatility. Significant variance between the two metrics signals a seminal shift in risk perceptions or some market inefficiency.
If the November $40 MOO calls, for example, were priced with a 50 percent expected volatility (today, that’d be $2.31 a share), while historic volatility clocked in at only 32.5 percent, you probably ought to prepare yourself for wider price swings. That might mean tightening your money management stops on your open positions.
Conversely, if the options are priced with an implied volatility of only 20 percent, you might think twice about taking a position in the underlying asset. Either the market is underestimating the upcoming price volatility, or there’s an earnest anticipation of a relatively quiet market for the option’s tenure.
This is especially important in bullish markets, because standard deviations—i.e., volatilities—historically fall as prices rise. Volatility increases in bear markets.
So how do you determine these risk parameters? It’s easy, really.
If you’re acquainted with Excel spreadsheet protocols, you can derive an annualized historic volatility for any time period by keeping track of the day-by-day changes in the underlying asset’s price. Then, using the argument “=STDEV(RANGE OF CELLS CONTAINING DAILY PRICE CHANGES, i.e., “B3:B157″) *SQRT(252)” at the end of your data string will calculate your volatility factor. (Another option: You can obtain historic volatilities for 20-, 50-, and 100-day ranges on a wide spectrum of futures, stocks and other exchange-traded products at the Option Strategist.)
To derive implied volatilities, the Options Industry Council’s online pricing calculator is your best bet. It’s free and comes with lots of educational support.
With just a little effort, you can get the options market makers to offer up their insights on your favorite stock or fund. The best part is that you don’t have to be on their turf. You can pick these clues up online at your leisure.
VISIT HARD ASSETS INVESTOR: HERE