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
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
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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