The Black-Scholes option pricing model, which was discussed in Chapter 4, possesses six input factors: underlying stock price, strike price, time until expiration, implied volatility, dividends and the risk-free rate.
Of all the inputs, implied volatility is the most uncertain because it is based on future expectations and is constantly changing. Volatility can be measured in terms of past fluctuations (historical volatility) and expected future fluctuations (implied volatility). In the most basic definitions, we can say that:
Historical (Realized) Volatility (HV)
The previous annualized price fluctuations of an underlying stock over a period of time.
Implied Volatility (IV)
The expected future annualized price fluctuations of an underlying stock over a period of time.
As covered in lesson 5.7, Vega represents the change in option premiums with respect to changes in the underlying stock's implied volatility. Investors use historical volatility to assess previous price fluctuations of a stock. Implied volatility is used to assess future expected price movements. Because the future cannot be predicted, implied volatility is nothing more than a prediction that can change at a moment's notice.
When future price fluctuations of an underlying stock are expected to increase, implied volatility will increase. This in turn will increase the Vega value of an option contract, which increases option premiums (assuming all other price inputs stay the same).This is positive for investors who are long Vega and negative for investors who are short Vega.
The opposite is also true: when future price fluctuations of an underlying stock are expected to decrease, implied volatility will decrease. This in turn will decrease the Vega value of an option, which decreases option premiums (assuming all other price inputs stay the same). This is negative for investors who are long Vega and positive for investors who are short Vega.
Therefore, we can say that an investor could purchase a call option, watch the underlying stock price move upwards, and still lose money on the position because IV decreases. Or, an investor could purchase a put option, watch the underlying stock price move upwards, and still make money on the position because IV increases!
When market volatility is low investors typically looks get long volatility by purchasing options. When market volatility is high investors will look to get short volatility by writing options.
Chapter 7 will introduce students to the role that volatility plays in option pricing and ways to analyze volatility properly.
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