Unit 5. Volatility and options (In progress)

These are my notes on the chapter, Volatility and options, from the PDF, Options trader.

Objective

The objective of the volatility and options unit is to provide you with an understanding of how volatility impacts option trading

• The VIX
• Implied volatility
• Standard Deviation and the expected move
• Lesson reinforcement actions

The VIX

• CBOE Volatility Index ( VIX ) is a measure of the stock market’s expectation of explosiveness over the next 30 days
• Often referred to as the fear index
• VIX is calculated using a formula that uses the weighted average prices of the calls and puts of the stocks in the S&P 500 index
• A high VIX reading suggest the investors expect significant fluctuations in the stock market
• A low VIX reading indicates that investors anticipate a relatively stable market
• Started by CBOE in 1993
  • Revised in 2003
    • Collaboration between CBOE and Goldman Sachs
• VIX options began trading in 2004
• Historical average for VIX is around 17
• Levels below 20 suggets low explosiveness and relative market stability
  • Investors tends to be complacent
    • In 2017, average VIX closing price was 11.09
• Levels between 20 and 30 are signs of uncertainity
  • Investors tends to be more fearful when VIX is over 30
• VIX can reach extreme levels
  • 2008 and 2009 financial crisis, the VIX exceeded 80
    • Average closing price for those two years were 32.69 and 31.48
  • VIX exceeded 80 again during COVID pandemic in 2020
    • Average closing price was 29.25
• Second only to the price of the underlying asset the VIX has a significant impact on the price of the options
• Two reasons why VIX impact options prices
  • Usually the VIX has an opposite relationship to the S&P 500
    • As the VIX rises, the stock prices declines
      • This increases the intrinsic value of option prices
    • When VIX increases, option prices increase due to expectation of increased volatility
      • It is expected that stock price movement will increase which creates more uncertainty

Implied volatility

Implied volatility is a concept used to describe the market’s expectation for the future volatility of the underlying asset. it represent the estimated future volatility of the asset, as suggested by the price of the option.

The extimate is based on the asset historical explosiveness

Future explosiveness is simply an expectation of a possible range of price outcomes

This range of possible outcomes expands further out in time that is being considered

An analogy is used here with a handful of marble. If we drop them from our knee height, the marble will land on the floor and disperse. If we drop them from our waist height, the marble will land on the floor and disperse further.

The concept is graphically illustrated with a cone of probability using standard deviation of 1.0, 2.0, and 3.0

Each of the cones represent a range of expected price outcomes

In the illustrated example, the actual price stayed within the 1.0 deviation from the original point of reference

The implied volatility is displayed in the broker’s option data and is a key factor affecting an option’s price

Option prices are based on multiple factors

• Current price of asset
• Strike price of option
• Time to expiration

• When traders and investors expects the asset to be more explosive in the future, they will demand a higher price for options that give them the right to buy or sell the asset at a specific price
• The higher price reflect the increased risk and uncertainity associated with the asset

Notes

Exercise and assignment

Lesson reinforcement actions