Options Trading Lesson: Volatility (charanga-44650)

How to understand the consequences of volatility on the options trading indicators.

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.

See Also:
Understanding the Risks and Rewards of Joining a Stock Trading Clubs - Stock markets are fascinating environments. But with unpredictable swings in prices, bull and bear phases, and stories about people making and losing millions overnight, they can also be intimidating to a beginning investor.

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.

See Also:
Finding Your Dream Home In Summit New Jersey - Are you sick of the hustle and bustle of New York City? If you are looking for a wonderful suburb to call home that's only about an hour from metropolitan New York City via public transport, consider Summit New Jersey.

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.

See Also:
What Segregated Funds Are All About? - Insurance companies have come up with segregated funds as a battling sword against mutual funds. They combine the features of both mutual funds and insurance as in akin to mutual funds IVICs are also modes of investment and akin to insurance they provide guarantee and tax benefits. Let us...

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.

See Also:
What You Need To Know About Day Trading - If you are new to day trading, you might now realize that you can actually borrow money to buy stocks with

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.

See Also:
Investment Performance Analysis Using the Working Capital Asset Allocation Model - Every December, with visions of sugarplums dancing in their heads, investors begin to scrutinize their performance, formulate couldas and shouldas, and determine what to try next year. It's an annual, masochistic, right of passage. My year-end vision is different.

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.

See Also:
What Is Day Trading? - In India NSE BSE provide excellent day trading opportunities in Top100 stocks. Due to good volume of FII activities Indian Stock Market is having good liquidity to day trade. We would suggest before starting day trading one should start with short swing trading as patterns and chart formations...

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.

See Also:
Probability And Investment! - How to increase the odds of your stock investment winning by using probability.

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.

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

See Also:
FIVE MAIN STEPS TO GETTING YOUR FINANCES IN ORDER - In our world of dizzying change, nothing is truer than the time honored statement that circumstances always change. No where is this more true than with financial issues. Have you ever borrowed money, or charged up the VISA card at Christmas, all the while telling yourself that you would...

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

See Also:
Commodity Trading - A Brief Overview - Commodity Trading is a popular area for day traders as well as longer term investors. This article explains some of the basics terms and concepts of commodity trading for those new to the subject.

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.

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

See Also:
Learn To Avoid Market Timing - I have mastered a low-risk, high-reward investment strategy that has helped my portfolio

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.

About the author: 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 http://www.optionsuniversity.com or 866-561-8227