UNDERSTANDING VOLATILITY

The value of an option depends mainly on two things:

The likelihood that the option will finish in the money. The difference between the underlying price and the option's exercise pric if the option does finish in the money. Effectively, the value of an option depends on the distribution of possible underlying prices, which depends on: How much the underlying price is likely to change on any given tradin day during the option's life (daily volatility). How many days the underlying price will have an opportunity to chang before the option expires (the option's time to expiration in trading days).

TWO TYPES OF VOLATILITY

1. HISTORICAL VOLATILITY:**

A statistical measure of the past volatility o the underlying price. If a trader intends to use a theoretical pricing model he must try to make an intelligent guess about the future volatility. In option evaluation, a goo- starting point is historical data. Converting Underlying Price Volatility:

Rules of Thumb: Annualized price volatility is about 16 times greater than daily price vola Weekly price volatility is about 7.2 times greater than daily price volatility

2. IMPLIED VOLATILITY:

The volatility being implied to the underlying contract through the pricing of the option in the marketplace. Effectively, it is the volatility estimate which matches the observable market price of the option with its theoretical value. It is the volatility we must input into our theoretical pricing model to yield a theoretical value identical to the price of the option in the marketplace. Remember, the more volatile the underlying market is expected to be over the life of the option, the higher the option price. Why Are Implied & Historical Volatilities Different? Gap or Jump Risk Expectations Supply and Demand Risk/Liquidity Premium Standard Deviations: ** The most widely quoted volatility measure is a standard deviation of percent changes in the underlying price.

1. One standard deviation of returns captures about 68% of all possible outcomes.
2. Two standard deviations of returns captures about 95% of all possible outcomes.
3. Three standard deviations of returns captures about 99% of all possible outcomes mplications for Trading: A one-standard deviation change in the underlying price (using the option's implied volatility scaled to suit the time horizon) represents a break-even level of underlying volatility vs. implied volatility. The distributions of returns on a long (purchased) option position is large gains. characterized by a high frequency of small losses interrupted by occasional large gains