S&C Magazine Current Contents Q & A Explore Your Options REALITY CHECK
REALITY CHECK
- Details
- Parent Category: Q & A
- Category: Explore Your Options
- Written by Tom Gentile
How can an option be priced at one volatility level and the underlying movement of a stock trade at a different one? Shouldn’t traders be able to exploit this phenomenon somehow?
What you’re seeing is largely due to traders’ collective forecast of a stock’s or index’s underlying movement. Essentially, implied volatility is how traders vote on what they think about both current and future market conditions, which might include a catalyst such as earnings or an FDA announcement that’s anticipated to move shares dramatically.
The pricing of implieds could also be the result of information unknown to you and me. Despite the leveling of the market’s playing field in recent years, the surface can still be uneven at times.
A second factor causing a disparity in volatility levels could be the hedging assumption in the pricing of volatility. A pricing model like Black-Scholes assumes perfect hedging scenarios and continuous prices at which traders can shift their deltas at a moment’s notice without incurring real-world inconveniences such as fast markets or price gaps.
That said, what statistical volatility is supposed to be on paper versus how it might be traded consistently can be two different animals. A $50 stock might show an average trading range of three points daily over an extended period but trade in a much narrower range for 95% of the session. If a good portion of each day’s trading range is unavailable to trade for whatever reason, premiums will look deceptively cheap.
At the end of the day, if the traders’ long premiums aren’t able to manage their time decay effectively, the net result could manifest itself in deceptively cheap-looking implieds versus the reported underlying volatility.
