Options Trading Forum

October 2nd, 2002

Understanding Volatility
Sheldon Natenberg Chicago Trading Co. 440 S. LaSalle St. Chicago, IL 60605 (312) 863-8004 shellynat@aol.com

exercise price time to expiration underlying price

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interest rate volatility (dividends)

pricing model

theoretical value

90 20% 10%

95 20%

100 20% 40%

105 20%

110 10% 20%

long an underlying contract 10%*90 + . + 10%*110 = 100 long a 100 call 20%*5 + 10%*10 = 2.00 Expected Return
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The theoretical value is the price you would be willing to pay today in order to just break even. If the expected return of the 100 call is 2.00, what is its theoretical value? interest rates = 12% 2 months to expiration 2.00 - (2.00 x 2%) = 1.96

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underlying prices probabilities

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normal distribution

Standard deviation how fast the curve spreads out.

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Mean where the peak of the curve is located

All normal distributions are defined by their mean and their standard deviation.

100 + .25 each day value =.05 + 2.00 each day value =.75 80 put + 10.00 each day value = 8.00 90 days to expiration 120 call option value

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+1 S.D. 34% -1 S.D. 34% +2 S.D. 47.5% -2 S.D. 47.5%

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mean

1 S.D. 68% (2/3) 2 S.D. 95% (19/20)

-1 S.D. +1 S.D.

-2 S.D.

+2 S.D.

Mean the break even price at expiration for a trade made at todays price (forward price) Standard deviation volatility Volatility: one standard deviation, in percent, over a one year period.
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1-year forward price = 100.00 volatility = 20% One year from now: 2/3 chance the contract will be between 80 and 120 (100 20%) 19/20 chance the contract will be between 60 to 140 (100 2 x 20%) 1/20 chance the contract will be less than 60 or more than 140

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What does an annual volatility tell us about movement over some other time period? monthly price movement? weeky price movement? daily price movement? volatilityt = volatilityannual x v t
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Daily volatility (standard deviation) Trading days in a year? 250 260 Assume 256 trading days t = 1/256 v t = v 1/256 = 1/16
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volatilitydaily volatilityannual / 16

volatilitydaily = 20% / 16 = 1% One trading day from now: 2/3 chance the contract will be between 98.75 and 101.25 (100 1%) 19/20 chance the contract will be between 97.50 and 102.50 (100 2 x 1%)

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Weekly volatility: t = 1/52 v t = v 1/52 1/7.2 volatilityweekly = volatilityannual / 7.2

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Monthly volatility: t = 1/12 v t = v 1/12 1/3.5 volatilitymonthly = volatilityannual / 3.5

stock = 68.50; volatility = 42.0% daily standard deviation? 68.50 x 42% / 16 = 68.50 x 2.625% 1.80 weekly standard deviation? 68.50 x 42% / 7.2 = 68.50 x 5.83% 4.00

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stock = 68.50; volatility = 42.0% daily standard deviation = 1.80 +.70 +1.25 -.95 -1.60
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+.35

Is 42% a reasonable volatility estimate? How often do you expect to see an occurrence greater than one standard deviation?

8
0

normal distribution

lognormal distribution

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underlying price = 100 normal lognormal distribution distribution 3.00 3.00 110 call 90 put 3.00 2.50 110 call = 2.75 90 put = 3.00 Are the options mispriced? Could there is something wrong with the model?

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future volatility : The volatility of the underlying contract over some period in the future historical volatility : The volatility of the underlying contract over some period in the past forecast volatility : Someones estimate of future volatility
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implied volatility : derived from the prices of options in the marketplace the marketplaces forecast of future volatility
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implied volatility exercise price time to expiration underlying price interest rate volatility 27%
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31% ??? pricing model

3.25 theoretical value 2.50

Option trading decisions often begin by comparing implied volatility = price to future volatility = value historical volatility forecast volatility

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Volatility Trading Initially buy underpriced options or strategies, or sell overpriced options or strategies Offset the option position by taking an opposing market position, delta neutral, in the underlying contract Periodically buy or sell an appropriate amount of the underlying contract to remain delta neutral over the life of the strategy (dynamic hedging) At expiration liquidate the entire position In theory, when the position is closed out the total profit (or loss) should be approximately equal to the amount by which the options were originally mispriced.
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Volatility Trading Risks You may have incorrectly estimated the future volatility The model may be wrong
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SPX Historical Volatility January 1990 - August 2002

35%

50-day volatility 250-day volatility

30%

25%

20%

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15%

10%

5% Jan-90

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Volatility characteristics serial correlation in the absence of other data, the best volatility guess over the next time period is the volatility which occurred over the previous time period. mean reversion volatility tends to return to its historical average momentum a trend in volatility is likely to continue

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Volatility Cones
40

38

36

34

implied volatility (%)

32

30

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28

26

24

22

20 0 3 6 9 12 15 18 21 24 27 30 33 36 time to expiration (months)

Volatility Forecasting Methods (G)ARCH (generalized) autoregressive conditional heteroscedasticity (V)ARIMA (vector) autoregressive integrated moving average

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SPX Daily Price Changes: January 1990 - August 2002

250

225

200

175

number of days: 3186 biggest up move: +5.73% (24 July 2002) biggest down move: -6.87% (27 October 1997) mean: +.0364% standard deviation: 1.0217% volatility: 16.24% skewness: -.0263 kurtosis: +3.9072

150

number of occurrences

125

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100

75

50

25

0 -7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

daily price change (nearest 1/8 percent)

Volatility Skew: The tendency of options at different exercise prices to trade at different implied volatilities
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A consequence of how people use options weaknesses in the pricing model

SPX June Implied Volatilities - 22 February 2002

38

36

34

32

30

28

26

-30-

24

22

20

18

16

14 750

800

850

900

950

1000

1050

1100

1150

1200

1250

1300

1350

1400