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Hello and welcome.
In the last video, we took our first look at option pricing. In this video, we will continue with option pricing by taking a closer look at volatility.
Volatility can be broken into 2 parts- Historic Volatility, and Implied Volatility.
Historic Volatility is the volatility of the Periodic Daily Returns. The Periodic Daily Return is the rate that price changes each day using continuous compounding. Each day, the price of a stock is the previous day's price times e raised to some value. The value that e is raised to is the rate of change for that day, in other words, the Periodic Daily Return.
Historic Volatility refers to the Standard Deviation of the Periodic Daily Returns. The standard deviation shows the rate of dispersion, or how spread out the Periodic daily Returns are from the average of all of the Periodic Daily Returns.
In short, Historic Volatility is the Standard Deviation of the Periodic Daily Returns over a 1 year period. For more on this, please what my video on the Period Daily Return, and my 3 video series on the Standard Deviation.
Implied volatility shows the market's opinion of the stock's potential moves,
In other words, Implied Volatility shows what the market "implies" about the stock's volatility in the future.
When Implied Volatility is high, then the market thinks that the stock has potential for large price movements in either direction before the option expires. When Implied Volatility is low, then the market thinks that the price of the stock will move less by option expiration.
Implied Volatility is affected by things like upcoming earnings reports, and upcoming economic announcements. For instance, in the days leading up to an earnings report, Implied Volatility will increase due to the uncertainty of what the results of the report will be, and after the earnings are announced and the results are known, Implied Volatility will decrease.
Volatility is the largest factor in determining option pricing. Let's say that there are two stocks that are both priced $10 per share. One of these stocks goes up and down about 1% or 10 cents each day, and the other stock goes up and down about 3% or 30 cents each day.
Let's say that a trader buys $12 Call Options on both stocks. This locks in a pre-set buy price of $12, so this trader is hoping that both stocks rise above $12 before the options expire. The stock that moves around 3% each day on average has a better chance of rising over $12 than the stock that only moves 1% each day on average. Therefore, the option for the stock that moves 3% a day will be priced much higher than the option for the stock that only moves 1% a day. In other words, the higher the volatility, the more the cost of the option.
Volatility is used to form a range around the expected path for price to create a continuous range of probability for what the actual rate of change in price will be.
By combining some basic assumptions about the markets with some basic laws and theories of statistics, we can develop an expected path for price. In other words, we can determine the path for price that has the greatest odds of occurring. Even though we know price probably will not follow that path, it is the path that has a better chance of occurring that any other path. Therefore, we call it the expected path for price.
We can take that expected path of price along the volatility, and form what is known as a probability distribution of what the future path of price will be. In other words, we take the expected path of price, and the volatility, and form a range around the expected path that tells us the probability or odds of any path occurring.
We can use this to determine the probability of what the future price will be, not only for pricing options, but also for things like Monte Carlo Simulation, which is used to determine possible future outcomes of price, and Value At Risk, which is used to determine things like expected maximum risk of loss.
In the last video, I mentioned that option pricing only has 5 inputs or 6 if the stock pays a dividend. The Strike Price is fixed, but the stock price, the volatility, and the amount of time left until the option expires are constantly changing, and interest rates may change at any time. As these values change, they affect the price of the option. In the next video, we will begin to look at how these changing values affect an option's price by taking our first look at the Greeks. See you then.