Black-Scholes and related option formulas tell us that under a bunch of conditions there is a fair price for an option that is based on the volatility of the underlying stock (or whatever underlies the option). The derivation of Black-Scholes is a really neat piece of math and if you can go through it you will be enlightened. But unknown to this "moneymantra" (which must be written by idiots because nearly everything I see posted by them is wrong) Black-Scholes doesn't use "historical volatility". It uses the volatility between now and option expiration which is of course unknown. When moneymantra says " Many option traders, however, rarely assess the market value of an option before establishing a position. This has always been a curious phenomenon, because these same traders.." that's their problem. Since Black-Scholes requires future unknown volatility and they think it uses historical volatility they think option traders have messed up. Pretty funny.
So an option has a dollar price. A Jan 15 100 call for AAPL is selling for $4, say. I can use Black-Scholes to say what volatility in that formula says $4 is a fair price. The volatility I get is the volatility of the stock implied by the option price called the implied volatility. You can get this implied vol using Excel or any number of online B-S calculators. Be careful as calculating implied vols is fraught with trouble.
The nasty thing of course is that there is not a unique implied volatility because each option has its own implied vol. There have to be connections between these option prices but that is also full of nuance. So your booklet is misleading because there is not one "implied vol".
FWIW - Trying to manage risk on your stock portfolio using implied vols from options must work. But I have known the risk managers from all the biggest hedge funds and talked to risk guys at all the major software vendors and the track record for getting this to work is really bad. It seems that everyone who tries it with millions of dollars ends up running through their budget and then saying, "You know - option implied vol is a nice idea but the options market and the market in underliers are just different". In the end, everyone ends up thinking there is value there but it is too hard to get and abandons you for mysterious reasons.
Anything with a fluctuating price has a measure of volatility. Vol is simply a diversion from the mean. It's calculated as the square root of the average squared deviation of the data from its mean. Vol within the stock market is generally used to measure risk or fear. In the options market volatility is an input within the option pricing model. As a result, the more volatile the underlying, the more expensive the option contract. This is called the risk premium. Hope this helps.
Thanks for taking the time and posting your answer. Kaveh
Hi,
I was reading a booklet about options. The author was suggesting some criteria on the Underlying Stock. one of them was " Implied Volatility under 30 for the Underlying Stock".
I know from my past studies that the Volatility is used for options but I am not really sure if that could be used for Stocks as well. Do I get it wrong? If it can be used for the Underlying Stocks too, could you please tell me where should I look it up or how could I calculate it?
Thanks
