Options Trading Lesson: Volatility
Topics: options trading, options trading strategies, stock options trading, stock trading
To get a firm grasp of volatility’s effect on vertical spreads, let us examine three spreads against different implied volatilities while keeping the stock price constant at 67.5. These are the 60 - 65, 65 - 70 and 70 - 75 call spreads.
In-the-Money Vertical Spreads
Looking at the in-the-money spread (June 60 - 65), we see that as volatility increases, the value of the spread decreases. This is because with the increased volatility, the stock has a greater tendency to move. That brings a higher probability of the stock moving to a price where the June 60 - 65 call spread will no longer be in-the-money.
To adjust for higher volatility risk, the spread will have less value. A general rule of thumb is that as volatility increases, the value of an in-the-money vertical spread decreases. Conversely, an in-the-money vertical spread’s value increases as volatility decreases.
At-the-Money Vertical Spreads
A change in volatility has very little effect on the at-the-money vertical spread (June 65 - 70). With the stock price located equidistant from the two strikes, each strike’s volatility component will be very similar. Therefore, both options will increase equally once volatility increases. Being long on one and short on the other, the increase in values will offset each other so the spread’s value will hold fairly constant. When volatility increases or decreases, the value of an at-the-money vertical spread will stay reasonably constant.
Out-of-the-Money Vertical Spreads
The out-of-the-money vertical spread (June 70 - 75) has the opposite effect of the in-the-money vertical spread (June 60 - 65). As volatility increases, the value of the out-of-the-money vertical spread will increase. This is because the increase in volatility assumes that the stock price is more likely to move. Thus, the out-of-the-money vertical call spread is more likely to finish in-the-money.
Because of this spread’s increased potential to finish in-the-money, its value will increase. The spread’s value will decrease if volatility decreases. On the other hand, an out-of-the-money vertical spread’s value increases when volatility increases.
When trying to estimate how your spread will change in price with volatility movement, you must understand how the price and Delta of both of your options - long and short - will act.
It bears repeating again that each spread is different and will act differently depending on where the stock is in relation to the spread and what implied volatility does.
Median Value
An important thing to note is that when volatility increases, spreads crunch to their median value. For example, the median value of a $5.00 spread will be $2.50 while a $10.00 spread will have a $5.00 median value.
Crunching to the median value means that a $5.00 spread with a median value over $2.50 will lose value and head toward the median price. That happens with an increase in volatility. Meanwhile, increased implied volatility will make a spread with a value less than $2.50, increase in value and rise toward median value.
When implied volatility decreases, the value of a $5.00 spread will move away from the median price of $2.50. Therefore, when implied volatility decreases, all the spreads valued above $2.50 will increase in value toward maximum value. Spreads valued below $2.50 will lose value and head toward $0.
The Effect of Time
Time affects the spread differently depending on where the stock is. Look at the QCOM 65 - 70 call spread. Look at the spread’s reaction to the passing of time with the stock price of $65.50.
The chart below shows what the spread’s value does as expiration approaches.
Month Months to Expiration 65 - 70 call spread value Change from prior
Jan. 05 (8 month option) 2.06 N/A
Oct. 04 (5 month option) 2.05 -.01
Jul. 04 (2 month option) 1.92 -.13
June 04 (1 month option) 1.65 -.27
With the stock at $65.50, the spread has $.50 of intrinsic value. Holding the stock price frozen at $65.50 until expiration, the spread would be worth $.50. The table above shows that the spread loses value as time passes and decreases in value toward its $.50 intrinsic value.
Next, look at the 65 - 70 spread’s reaction to the passage of time with the stock priced at $67.50.
Month Months to Expiration 65 - 70 call spread value Change from prior
Jan. 05 (8 month option) 2.33 N/A
Oct. 04 (5 month option) 2.37 +.04
Jul. 04 (2 month option) 2.44 +.07
June 04 (1 month option) 2.47 +.03
With the stock price located directly in between the two strikes, the price of the spread holds at approximately $2.50 throughout the passing of time. Take note that time has very little effect on a vertical spread when the stock price lies halfway (equidistant) between the two strikes of the spread.
Now, set the stock price at $69.50 and observe how the spread reacts over time.
Month Months to Expiration 65 - 70 call spread value Change from prior
Jan. 05 (8 month option) 2.55 N/A
Oct. 04 (5 month option) 2.67 +.12
Jul. 04 (2 month option) 2.96 +.29
June 04 (1 month option) 3.27 +.31
This spread increases in value as time passes. With the stock at $69.50, the spread has an intrinsic value of $4.50. If the stock held at $69.50 until expiration, the spread would be worth $4.50 because that is the amount of the spread’s intrinsic value. As time passes, the spread’s value will increase to finally reach $4.50 at expiration.
In conclusion, time’s effect on a vertical spread is contingent on where the stock is in relation to the spread.
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at www.optionsuniversity.com or 866-561-8227
Previous Articles Highlighter:
How Much Can Credit Card Debt Hurt Your Finances? (1)
The home business option is not for those who need money immediately. There's risk involved. You probably won't earn significant amounts quickly. But it can also be a lot more fun.
Do Not Take On Your IRS Problems On Your Own (2)
However, in case you choose to represent yourself you lose this first line of defense. A tax attorney will help you make the most of the protection the Congress gave you as a taxpayer.
Can They Come After My Home If My Investment Property Goes Into Foreclosure? (3)
Instead of creating more problems in the future, just simply resolve the problem by selling the property and getting your hands on more usable money. After paying off the required mortgage that was due on the property, you can then use any additional income from the sale to make payments on all properties that you own.
Investment Politics 2008: What's (left) In Your Wallet? (4)
collectively, constructively, and quickly. In this rapidly "flattening" world, our non-leaders (in both parties) are unwittingly making us less competitive globally, more protectionist at home, and less attractive to foreign investment than ever before.
FAQ - What Is Financial Spread Betting (5)
On any given day you can find out on the web or by placing a call to a spread betting firm to find the "spread" on the FTSE 100. They will give a spread such 6350-6500 (6500 to place a "buy" or "up" bet and 6350 for a "sell" or "down" bet).
Dealing With IRS Appeals (6)
The IRS will then process your appeal request and provide you a date and place for the meeting. You will have to prepare all the necessary documents with your tax attorney.
How Do You Spell Correction? (7)
The direction of the market isn't nearly as important as the actions we take in anticipation of the next change in direction. Performance evaluation needs to be "rethunk" in terms of cycles!
Personal Debts: Getting Out Of The Debt Trap (8)
If you really expensive coffee, you can treat yourself to a couple of cups per week and nothing more. Aside from brewing your own coffee, it would be best to start bringing your own lunch to work and cook your own dinner instead of eating out.
How To Cope With Chapter 13 Bankruptcy (9)
A trustee works for both parties and will usually come up with a three to five year payment plan which offers to pay off all or part of the debts owed.
Cashflow Clinic: Common Questions Asked When Businesses Want To Expand Using Invoice Finance (10)
Alternatively there are finance providers in the Factoring and Discounting market that can provide a small firms loan to support the current working capital facility. John Mce writes for Hilton-Baird Financial Solutions(www.hiltonbaird.co.uk) who offer free independent business finance advice and has helped over 2,000 UK businesses raise extra capital.
Using A Reverse Mortgage To Purchase A Home (11)
Some wish to keep their current homes but want a second home near children and grandchildren, near favorite activities, or in climates more favorable during certain times of the year.
HUD Insures First Fixed Rate Reverse Mortgage (12)
It used to be that senior borrowers basically had the choice between a monthly or annual adjustable rate mortgage. Borrowers still have the choice of those adjustable rate mortgages (and now with different indices as well with the recent introduction of the London Interbank Offered Rate or LIBOR rates), but now borrowers can also opt for fixed rate mortgages as well!
What Are Certificates Of Deposts? (13)
For those who have extra cash and can afford to invest it and leave it alone until maturity date arrives, certificates of deposit are a good idea. They are a safe and effective means of earning interest on your money.
How To Pay Back A Lot Of Student Loans To Save Your Credit (14)
Being a student should be fun and a great experience. Juggling education with student loan debt can easily be done, for thousands have for years. The trick is, live life like a college student while you're in college so you can live life like a well-educated and mature human being ready to begin life on a firm foundation without major debt.
Should I Use My Loans To Invest (15)
Technically, using your loan money for 'alternative' purposes may not be illegal. There is a possible risk that your lender will take legal action against you if they find out that you have used the money in a different way than you promised.
Uncovering Reverse Mortgage Myths & Misconceptions (16)
Myth #4 A reverse mortgage will affect my social security benefits. Reverse mortgages do not affect a senior's social security benefits. We recommend that seniors consult with a trusted financial advisor because need-based programs such as Medicaid, can be affected if the reverse mortgage is not administered correctly.
Where Can Mothers Get Small Business Loans (17)
It is a good idea to map out these expenses ahead of time to ensure that you don't get in over your head. Next you need to create a business plan, figure out the amount of start-up capital and to plan for your future financial needs.
Borrowers 'Need To Plan Ahead' (18)
This may increase the chances of interest rate cuts sooner rather than later if inflation remains subdued. Borrowers should make a new year resolution to review their finances and plan ahead if they are coming off fixed-rate deals later this year." The CML also put forward that despite previous demand for secured loans in the face of constrained supply, requests for borrowing are now set to diminish.
Securing Your Account Details (19)
Arguably there is not much more they can do; fraudsters are always looking for ways into the system and will endeavour to prolong their underhand business activities. In what has been labelled a 'technological arms race' the banks are one step ahead for the moment, they will however have to think fast to stay ahead of the criminals who constantly look for ways to cheat people out of their finances.
Is It Smarter To Invest My Money Or Pay Off Debt (20)
While having a savings account is a way to plan for the future, becoming debt-free is an excellent strategy for creating long-term health. Take a look at your savings account statements to see how much interest you're earning.
Newer Articles Highlighter:
Differences In Tax Services (1)
Most will offer significant discounts to returning customers in the form of free preparation for State tax forms if the person has the Federal tax forms prepared for the current tax year.
Which Is Better, Investing Or Owning A Business? (2)
However, depending on the types of stocks you are investing in, you can avoid a lot of the cons that come with starting a business. For example, you can actually be very profitable in a short time with the right stocks, such as penny stocks.
Here's How You Can Buy A Home - Even If You've Had A Foreclosure (3)
Since you had to foreclose on your last mortgage, you will be better off and more likely to be accepted for a smaller mortgage. There are many lending companies that cater to people with poor credit so try and use them to find a reasonable mortgage for the new house that you want to buy.
What Is An Installment Loan And How Do You Use One? (4)
Topics: installment loans, credit repair, personal loans There exist several various kinds of borrowed money that are able to be acquired in our money based society, which largely depends on your personal income scenario and the overall economic situation of the country you live in.
Cash Flow Management Issues Relating To Funding And Investment In A Credit Crunch (5)
There are benefits to reviewing the number of sources of finance and funding available to the business and the interest being charged. Relying upon one funding source may be putting all the eggs in one basket.
Guidelines For Settlement Loans In India (6)
The specific RBI guideline is very strict and will not change due to laws that will be effective next year. An additional RBI guideline has to do with when the loan will be completed covered by the central bank of India.
How To Get Debt Consolidation Online (7)
When getting advice for debt consolidation online you'll be wanting advice on two main options. The first option is a straightforward consolidation loan. While this seems an attractive proposition at first it does hold terrors a bit further down the line; even though the idea of consolidating all your payments into one big payment with a lower interest rate may appear to be good, that loan is more likely than not to be secured against your property, so if you default your home will be at risk.
Types Of Business Insurance In Sacramento (8)
There are many business owners, who feel that investment in owning a good coverage is not necessary, especially if they never got a chance to experience a disaster that would have proved worthy of such consideration.
Grandpa Is Playing With Risky Stocks Again (9)
Topics: investing, penny stocks, best penny stocks Some say you should only invest in risky stocks when you are young and can afford to lose money. Nonsense, first of all no one can just afford to lose money no matter how much time you think they have to recover from bad financial decisions.
4 Key Factors Concerning Your Future Career In The Stock Market (10)
If this is going to be your passion and life pursuit I would say go ahead and get school out of the way. It would just pay dividends, no pun intended, in the long run.
The Benefits Of A Direct Consolidation Loan For Students (11)
Borrowers have only one lender, the U.S. Department of Education, for all loans included in a Direct Consolidation Loan. Flexible Repayment Options: Borrowers can choose from four different plans to repay your direct consolidation loans, including an Income Contingent Repayment Plan.
Foreclosures - A Brief Explanation (12)
You may need to do some rehab work prior to the home being ready for sale, or there may be liens and judgments that need to be resolved. Short sales are homes that are about to become another foreclosures; however not all home foreclosures will result in a short sale.
The Bulletproof Investment Portfolio (13)
Safe with great potential, sounds like a winner to me. So Im going to recommend a 20% to 30% allocation here depending on your risk tolerance and long term goals.
Pre-Foreclosures: A Guide To Contacting The Owner To Purchase Before Auction (14)
Meeting at the property is much more productive, and professional. The owner will also have the documentation that you need to review there as well. The loan, insurance documents and foreclosure notices should be there; you will need them, if you intend on making an offer on the pre-foreclosure.
Stock Trading Online - What You Should Know About Stock Trading Online (15)
The network helps you connect with the buyer or seller. At times using the net as a means to trade with takes things to a whole new league. It makes your whole transaction much faster.
Small Business Loan: How To Obtain One Without Going To A Bank (16)
Get your new business started or grow your existing business the easy way today! Tiana Nelson, CMA is a Business Development Officer at Preferred Capital Alliance, Inc. (www.prefcapital.com) a Better Business Bureau accredited business finance consulting company that helps small- and medium-size businesses obtain financing to start and expand their operations.
The Advantages Of Consolidate Student's Loan (17)
If you are going in to consolidate your student loans you can work out some major benefits for yourself if you take into considerations the following factors. You can reduce your monthly payments up to 50% if you extend your repayment duration.You can refinance the outstanding federal student loans into one new loan with a lower rate of interest.
Is It Possible To Trade Forex Without Using Technical Indicators? (18)
Finally, if fundamental analysis and technical analysis aren't your thing, then you can always use the only meaningful indicator you really need - price. After all the price history tells you how the currency has behaved in the past, and if read correctly can be used to predict future movements as well.
Understanding What A Debenture Is And How It Can Help You (19)
In return for using your money, the company promises to pay back the full amount of money they initially borrowed plus interest over an extended period of time. Businesses also offer objects that give you monetary security during situation when they are unable to pay back the amount of borrowed money and interest in the form of immediate cash.
Homeowners Set For 'Rough Ride' (20)
The uSwitch representative stated that in particular those who have never switched should do so now, while the only people who can have the luxury to "sit back" are homeowners who are already on a competitive online energy deal.