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Volatility explainedVolatility explained
drdan said: "OK I am bordering on a diatribe here but I had a question through PM about volatility and I am reposting my response here...
Volatility is one of the most important aspects when it comes to pricing of an option. An option has an intrinsic value and an extrinsic or time value.
The intrinsic value is the difference between the strike price and the actual price of the option. For example in a call, if the stock is at $20 and the strike price you have chosen is $15 there is $5 worth of intrinsic value in the price of the option. IF the stock is at $20 and you have a strike price of $25 there is no intrinsic value priced into the call option, it is all extrinsic value.
The extrinsic or time value of an option is calculated based on the Black-Scholes model, but it is not necessary to know this as long as you know that it is calculated by how much time is left till expiration and the volatility of the stock. The higher the volatility the higher the option price. The more time left till expiration the higher the option price.
Volatility or more specifically implied voaltility is a guess (that's right a guess) at how the price of a stock is going to move. For example with our example in the forum of DNDN the guess is, because of the pending announcement, the stock is going to move a great amount. Volatility is independent of the direction, except that you may note that volatility usually increases as a stock becomes bearish and heads downward. Or look at GHCI, it is a very flat chart and the volatility is 5, because the guess is the stock is not going to move much.
Volatility can move up and down and it does fluctuate. You need to compare the implied volatility with the hostoric volatility to see if a stocks volatility is high or low. Actually the best way is to look at a 6 month or 1 year volatility chart to determine if volatility is high or low. Sell options on high volatility because there is better prices to sell. Buy on low volatility. And the best way to trade options is to figure out if volatility will be changing soon and then take advantage of that change.
Other sources of information include - CBOE and ivolatility.com"
marketreflections said: "drdan,
Your explaination on Volatility is right on money. Just curious about DNDN, if you have any trade, and you don't have to disclose. A good example."
drdan said: "Yes I have a Bull Put Credit Spread 12.50/15.00 for $1.30.
It is a risky credit spread as far as success but very low capital. I am waiting for an announcement on or before May 15th.
A previous discussion was done here - [url]http://www.superiorinvestor.net/thread5322.html[/url]"
Lightspeed said: "[QUOTE=drdan]OK I am bordering on a diatribe here but I had a question through PM about volatility and I am reposting my response here...
Volatility is one of the most important aspects when it comes to pricing of an option.....
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Just wanted to say thanks to Dan for this concise explanation of volatility. He was answering my question on it. Cheers! :)"