Volatility and options

Volatility is a measure of uncertainty of the future price of a security

Options could be defined by three parameters from physics – distance, time, and velocity. The relationship between those is well known: distance = velocity * time. I covered distance and time last week. Today's write-up is about the third variable, velocity, known as volatility in financial markets.

In a previous article, I examined the paradox that even though the price reaches our target, we are still losers. The price reaches our stop loss, reverses the direction of movement, and shamelessly goes through our take profit. This is the principle of path dependency, i.e., the outcome depends on the path traveled.

The arrow of time turns the future into the present and the present into the past.  We are all equal before time. A conclusion that is valid in life and financial markets. When investing, we wager on future events. Therefore, the outcome of our actions is a function of time.

Our investment performance depends on time. It could be a friend or foe. Time is a friend for bond investors and option underwriters, while it is a foe for equity owners and option buyers. LEAPS call strategy puts us against the time. This means the time decay inevitably consumes our call options premiums.

By purchasing call options, we become path-dependent immune while we pay with time and volatility dependency. However, volatility could be our ally if we pick our calls wisely.

That being said, volatility dependency makes LEAPS calls so lucrative. If we find 12-18 months calls with implied volatility below 40% and our thesis plays out, we will profit handsomely. In other words, this means we are directionally right on underlying price and implied volatility.

Conversely, we pay excessive extrinsic value if we buy calls with high implied volatility. Extrinsic value is determined by the option’s volatility and expiration date. So, the higher the volatility, the higher the extrinsic value and the option premium (if all other conditions are equal).

In today’s write-up, I examine volatility, the most underestimated variable in the options universe. Of course, understanding volatility is not enough to become successful when using options. However, misunderstanding is a precondition for failure.

Let’s start from the basics: velocity.

Velocity

The farther we get per unit of time, the faster we move. This principle holds in the financial markets, too. We just need to replace speed with volatility.

In simple terms, volatility means price variability. Let's compare two companies:

• Company A - price per share for 2022: average - $100, lowest - $90, highest - $110.

• Company B - price per share for 2022: average - $100, lowest - $40, highest - $190.

In 2022, Company A (black) moved in a narrow range relative to Company B (blue), which is much more volatile than the former.

The faster the stock price moves, the greater the distance it travels per unit of time. The slower the stock price moves, the shorter the distance per unit of time. The former statement illustrates a highly volatile stock, while the latter is low volatile.

If the underlying moves at a declining rate (has relatively low volatility), the option value decreases, too. A lower volatility means decreasing the odds of our option ending ITM (in the money).

Remember the following characteristics of volatility:

Volatility does not depend on the direction of the price but on its variability.

Volatility is a measure of uncertainty of the future price of a security.

There are two types of volatility: historic and implied.

Historic and implied volatility

Historic volatility indicates the underlying asset's price change over the past period.

Example: historic volatility(20) = 25% means that for the last 20 days, the underlying asset's price has moved ±25% 68% of the time.

Historic volatility considers past price shifts. It is an indicator based on the annual standard deviation of the underlying price movement for one year back.

Implied volatility (IV) is initially confusing because it depends on the option price and describes the expected change in the underlying price over a future period.

Example: implied volatility = 20% means that over the next year, the underlying asset's price is expected to move ±20% 68% of the time.

The following graph illustrates this dependence.

The chart shows the price movement's bell curve. Those familiar with statistics are aware of its characteristics. The assumption that prices always follow the standard distribution is used in calculating option premium prices. Yet this is only partially true; the prices do not follow strictly a random-walk pattern, nor are the markets efficient.

Occasionally, in long-term trends over 12 months, the chart is skewed to the right, indicating that the odds of winning are in our favor. This is the statistical edge behind the LEAPS calls strategy.

 Let's consider the following example:

• Underlying price: $50/share

• Implied volatility: 20%

We already know that a 20% IV means that the stock price has a 68% probability of moving within ±20% in the next 12 months, in our case, between $40 and $60.

Implied volatility is automatically calculated for 12 months. In the context of the LEAPS strategy, I am only interested in annual implied volatility. If you hold positions for less than one year, you should calculate implied volatility for the relevant period.

Implied volatility depends on the option price, which is influenced by the balance between supply and demand. The more buyers, the higher the option price, hence the implied volatility.

Higher underlying prices are not mandatory preconditions for rising option prices and implied volatility. Examples are days before significant events—bankruptcy, merger or acquisition, or earnings reports. At such times, market participants' expectations are stretched to the limit. Then, the share price can move in a narrow range while increasing demand for options is reflected in their prices and IV. This suggests that market participants expect massive price amplitudes in the underlying, which results in rising option premiums and higher implied volatility.

Summarizing implied volatility:

• It depends on the option price.

• Describes the future underlying price movements.

High implied volatility indicates high demand for the respective options. Simply put, the options have already become relatively expensive. So, I follow two simple rules about volatility:

• I buy options when their implied volatility is (relatively) low, and I expect it to rise.

• I rarely buy options when implied volatility is high. Yet I still look for a catalyst indicating that implied volatility from high may go higher.

Those heuristics protect me against the adverse impact of poorly selected calls. In summary, I buy LEAPS calls when I expect a higher underlying price and rising implied volatility.

Final Thoughts

Our primary task as market participants is to manage risk. Options are the most comprehensive tool for risk management. Depending on our goals and skills, we can select from countless strategies with options.

LEAPS strategy is one of the simplest options, making it deceptively easy to implement. Nevertheless, there are pitfalls. Underestimating the importance of distance, time, and velocity and overestimating our knowledge is a harmful combination.

In my mini-series on options, I covered the basics. Consider those articles a primer into the options universe. If you find the LEAPS strategy attractive, take a look at my article on how to play miners without being a geologist.

A reminder: ask yourself why you pick derivatives over equity before using options. If the answer is to make more money, please stick to equity.