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The Basics Of Option Volatility

By Brad Wilson

When it comes to buying and selling options, most traders, whether beginners or experts, know a little about the Black-Scholes model of option pricing. This is a model developed by Myron Scholes and Fisher Black in 1973 and aimed at helping traders determine what the market value of an option was based on certain factors like the expiration time, strike price and historical volatility.

On the contrary, many traders don't use this or even an option calculator for that matter.

This type of behaviour generally occurs because traders believe that an option's value can increase when a call or put option is exercised. There are however, certain variables that can get in the way.

Think about this for a moment; can you really buy a car or a house without finding out the market price of the commodity? You wouldn't, because you would be concerned about paying too much or not being able to sell the asset at the right price later on. With regards to option, purchasing without researching can lead to a lower option value.

If you really want to understand the mysteries of option pricing and understand why careful assessment is needed, you need to take a good look at volatility. Let us now examine what volatility is and how it can affect option pricing.

Understanding Option Volatility

You can use volatility to calculate option pricing which will give you an idea on magnitude and rate of the price change of a derivative. This is used to define those changes that increase and decrease. In general, when the volatility is high, the price of an option is high, but when it is low, the option's premium will reflect it.

There are two major types of volatility:

The Historical Volatility- This is a type of volatility that refers to the known changes in an option's price. This type of volatility has a rate of change, similar to a car speeding down the road. However, while we can measure the speed of a car in hourly rates, that of changing rate takes a year. If the derivative has been moving along at a certain rate per year, we can theoretically expect it to move at the same rate in the future. Also, this accounts for trend or direction.

Learn How To Turn Volatility To The Profit Of Your Option Pricing- The Implied Volatility- The implied volatility uses the historical data and the current market prices to determine the option price. You can then calculate the current price using two of the closet out-of-the-money strike prices. This type of volatility has a huge affect on the price of options, which may be because it depends largely on the activity of the marketplace. To this end, when the implied volatility increases, the option prices does too.

If you loved trading currency or stocks, make sure you are getting the fair market price for your options. You must assess the option pricing and derivative and determine what the historical and implied volatilities are using for option calculator. Hand your option pricing and financial management issues to HedgeBook!

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