Saturday, 25 August 2012

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What Is Option Volatility?

By Brad Wilson


When it comes to buying and selling options, most traders, whether beginners or experts, know a little about the Black-Scholes model of option pricing. The Black-Scholes model was established in 1973 to help traders determine what the market value of an option was based on expiration time, strike price and historical volatility.

When determining the fair price of their options, many traders don't use this or even the option calculator for that matter.

This is because most traders believe that an option's value can increase when a call or put option is exercised. It is true that these may be the instance in many occasions but it is necessary you stop and think about the many variables that tend to get in the way.

Think about this for a moment; can you really buy a car or a house without finding out the market price of the commodity? You wouldn't, because you would be concerned about paying too much or not being able to sell the asset at the right price later on. With regards to option, purchasing without researching can lead to a lower option value.

You need to take a good look at volatility if you must understand the mysteries of option pricing and understand why careful assessment is needed. In the next section, we will examine the true meaning of option volatility and how it can affect your option pricing.

What Is Option Volatility?

You can use volatility to calculate option pricing which will give you an idea on magnitude and rate of the price change of a derivative. This refers to both changes that increase and decrease. In a nutshell, when the volatility is high, the price of an option is high, but when it is low, the option's premium will show it.

Volatility are of two types:

The Historical Volatility- This is a type of volatility that refers to the known changes in an option's price. This type of volatility has a rate of change, similar to a car speeding down the road. However, while we can measure the speed of a car in hourly rates, that of changing rate takes a year. If the derivative has been moving along at a certain rate per year, we can theoretically expect it to move at the same rate in the future. Also, this accounts for trend or direction.

Learn How To Turn Volatility To The Profit Of Your Option Pricing- The Implied Volatility- The implied volatility uses the historical data and the current market prices to determine the option price. You can then calculate the current price using two of the closet out-of-the-money strike prices. This type of volatility has a huge affect on the price of options, which may be because it depends largely on the activity of the marketplace. To this end, when the implied volatility increases, the option prices does too.

If you like trading currency or stocks, it is necessary that you are getting the fair market price for your options. Take the time to assess the option pricing and derivative and determine what the historical and implied volatilities are using as an option calculator. Hand your option pricing and financial management issues to HedgeBook!




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