Option traders can never fully understand the dynamics behind pricing of stock options and stock option price movements without understanding what volatility and implied volatility are. Volatility is defined as "Tendency to fluctuate Sharply & Regularly" at dictionary.com. Hence the saying,"A volatile market". Volatility can be calculated mathematically to arrive at an expectation of the amount of volatility in the underlying asset or market implied by current price data, hence the development of Implied Volatility. Implied volatility is the second most important price determinant of stock options other than the price of the stock itself.
What Implied Volatility does is to estimate the underlying asset's possible magnitude of move to either direction. The higher the Implied Volatility, the more the stock is expected to move and hence a greater possibility that the underlying asset will move in your favor. The lower the Implied Volatility, the more stagnant the stock is expected to be and hence the lower the possibility that the stock will move in your favor.
As such, the higher the implied volatility of the underlying asset, the more expensive its options become due to a greater possibility that it will end up in your favor profitably. This dynamic is represented in the greeks of every option contract as the VEGA.
Factors Affecting Implied Volatility
Mathematically, the factors that affect implied volatility are the exercise price, the riskless rate of return, maturity date and the price of the option. These factors are taken into consideration in several option pricing models, including the Black-Scholes Option Pricing Model. Implied volatility is also the only variable that goes into a mathematical option pricing model.
In reality, implied volatility of options is determined by market maker's assessment of public expectations regarding events that might change the value of an option. In one sided markets, market makers are charged with the obligation to sell options to buyers in order maintain liquidity. They then increase the value of the options through increasing their assessment of implied volatility so as to reap a greater profit. Conversely, when the market is selling off options, these market makers charged with the obligation to buy from these sellers, lowers the price of the options through lowering their assessment of implied volatility.
Options Vega
Options Vega measures the sensitivity of a stock option's price to a change in implied volatility.
There are 2 main component to a stock option's price; Intrinsic Value and Extrinsic Value. The price of the underlying stock relative to the strike price determines the Intrinsic Value, which is governed by Options Delta. Implied volatility of the underlying stock determines the Extrinsic Value, which is governed by Options Vega. In fact, for Out Of The Money (OTM) Options that contains nothing more than extrinsic value, their prices are 100% determined by Options Vega! When implied volatility rises, the price of stock options rises along with it. Options Vega measures how much that rise is with every 1 percentage rise in implied volatility.
Why Is Options Vega Important?
It is almost impossible to understand why Options Vega is so important without first a comprehensive understanding of Implied Volatility.
In short, the more a stock is expected to make a big move due to some important news release or earnings release in the near future, the higher the implied volatility of that stock is right now. In fact, implied volatility rises as the date of that important release approaches. This is also due in part to the higher demand for the options of those stocks as speculative heat builds up. Under such circumstances, market makers also hike implied volatility in order to charge a higher price for the higher demand. Which really means that implied volatility is largely at the mercy of market makers' whims and is its effects on the price of an option is measured by the Options Vega.
Since implied volatility rises as important news releases approach and since Options Vega made sure that the price of the stock rises along with it, wouldn't the few days running up to such events be perfect for buying options and hoping that the stock remains relatively stagnant so as to profit from the rise in implied volatility? Yes! In fact, many options traders take delta neutral and gamma neutral positions a few days before important news releases so as to profit from the rise in implied volatility safely and then closing the position just before the release.
The Team at American Option Trader LLC