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Options Volatility

Volatility measures the extent of price change per unit of time. High volatility occurs when prices fluctuate widely over a given period of time; low volatility is seen when prices remain relatively stable.

Two types of volatility are distinguished:

  • Historical volatility is calculated based on an underlying asset's price history;
  • Implied volatility is the market's assessment (�opinion�) of an underlying's future volatility � it strongly influences an option's market price (premium).

When an underlying has a high implied volatility, its options will have high time values. This is due to the higher probability of a seeing a substantial price move in the underlying (from its current position). A high implied volatility suggests a greater probability an option will become profitable before it expires.
Volatility is one of the key parameters that affect an option's price (premium).

Historical volatility (which is based on historical data) can be used to estimate future volatility. Commonly used is the standard deviation of an asset's returns expressed as an annualized volatility. A quick estimate of an asset's historical volatility can be made as follows: Double the difference between its 52-week high and low and divide this by the sum of the high and low.

Implied Volatility can be inferred from an options' current market price (premium) in comparison with its theoretical value (calculated by an option pricing model). In cases where an underlying's options are not actively traded or information on premiums is unavailable, one can use a known option's implied volatility to derive the premiums of the other options (on the same underlying).

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