Volatility refers to how wildly the price of a stock swings. Prices of stocks with high volatility change by larger percentages over the course of the average day, week or month compared to stocks with lower volatility. When purchasing an option on a stock, the volatility of the stock is a major consideration. In fact, the prevailing market price of the option tells volumes about the volatility investors expect to see in the stock. This concept is referred to as “implied volatility.”
An option is a flexible agreement to trade something on a future date. However, this trade only occurs if the option holder wishes to execute the option. Options that allow the option holder to buy something on a future date are referred to as call options, while those that allow the option holder to sell something are known as put options. While an option can allow trading anything of value, options are most frequently used to lock in a future price for stocks, bonds and currencies. An American option allows the option holder to execute the trade on any date before the option's expiration date, while European options allow the holder to trade only on the expiration date.
Assume you wish to buy Citibank stock but don't have the cash at the moment. You are worried that the stock will have appreciated by the time you can execute the trade, so you purchase a call option on Citibank stock. Such an option could have an expiration date of June 27, strike price of $10 and be valid for 1,000 Citibank shares. If Citibank stock advances to $12, you can purchase 1,000 shares on or before June 27 for only $10 instead of paying the market price of $12. If Citibank is trading at less than $10, it is more advantageous to ignore the call option and purchase Citibank stock at prevailing market prices.
Volatility is the average magnitude by which the price of an option changes within a set period. The price of a stock with high monthly volatility tends to change more over the course of the average month than the price of a stock with low monthly volatility. As an options investor, you want high volatility, because the greater the price swings in a stock, the more likely that the stock's price will have moved a great deal away from the option's strike price. If you have a call, the higher the stock's price compared to the strike price of the option, the more valuable your options. When you are holding a put, a wild downward swing makes your options more valuable.
By using the Black-Scholes options pricing formula and plugging in the present stock price, volatility, strike price and expiration date for an option, you can calculate how much you should pay for an option. If you see a sale price for an option, you can use the same formula to arrive at the volatility that would produce the specific option price. In other words, a specific magnitude of volatility is implied by the prevailing market price of the option. That's why stock investors often check option prices to deduce how volatile options investors expect the price of a particular stock to be.
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