As an options trader, implied volatility and time decay are two critical components to keep an eye on. This article will focus on volatility for those just beginning to dabble in options. At the end of the article a short explanation of time decay is included.
Markets determine option buy points by using forward-looking pricing models. A number of financial pricing models exist. Two of the most popular models include binomial option pricing and Black-Scholes option pricing, as explained by Penn’s Wharton School of Business in the above link.
Implied volatility is an estimate of an option’s future volatility and is determined (or implied) by live market prices. Because implied volatility can only be estimated it is important to understand the distinction between implied volatility and volatility:
Implied volatility: forward-looking volatility estimates linked to current price.
Volatility: observable historical figures that put implied volatility in perspective. This comparison helps a trader determine if an option is under or over-valued.
Volatility measures an investor’s risk. A financial instrument’s value changes over a specific time horizon. Collectively these values form a population. Volatility equals the positive square root of the population’s variance (or standard deviation for you statistics fans out there). The “time horizon” is typically a year and the “population” is the collection of daily price changes of the financial instrument. So we say that volatility is the “annualized standard deviation of a stock’s daily price changes.”
A fascinating side note about option valuation: did you know that beliefs regarding the movement of an underlying asset’s future value do not factor into an option’s valuation?! Clashing expectations about an asset’s expected growth and returns will not stop two people from entering into an option contract. Only agreement regarding volatility and the risk-free rate of return are necessary. The costs of hedging after writing an option always remain the same regardless of an asset’s price going up or down.
Time decay of an option is the idea that options carry expiration dates. An option is a contract that gives an investor the right to buy or sell a specific quantity of a financial security. They may buy or sell at a predetermined price until the date of expiration. Once the contract expires, it is valueless. Time decay refers to the notion that an option’s value erodes the closer it gets to it’s expiration day. Time decay is accounted for by The Greeks, statistical values that option traders use. Namely, theta represents the absolute value erosion for “one period” of time. For example, if the strike price of an option was $500 and theta was equal to $50, theoretically the option would lose $50 of value each day.
The first step for a newbie option trader is to get comfortable with using statistical values. Using the likes of implied volatility and volatility will help determine if an option is under or over-valued. The next step is developing trading strategies to effectively use those valuations.