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Neal: So give me an example of how you explain volatility over the Internet. |
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Don: You mean you want a sample Internet chapter? |
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Neal: Yes, why not . . . this book needs a "freebie." |
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Don: I call this Intermediate Commodity Options #25. |
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Volatility is a very difficult factor to explain, but it should not be that difficult to understand. An option that is out of the money has a hope that the futures price will move there before the time runs out. This hope could be based on many factors. One factor would be how the futures have been moving latelyhistorical volatility of the futures. If the futures are 1150, but they were over 1240 last week, then it would not be unreasonable to think the market might go back above 1240 in the next four weeks. Or, if the futures are 1150 now, but they were 1050 last week, then it might not be unreasonable to expect the market to rally another 100 points in the next four weeks. In this case, you would expect the 1240 call to have a significant value. |
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There is a formula to calculate historical volatility. I am not going to give you the formula here. Suffice it to say that you would need a computer to calculate historical volatility. What is done is to take a certain number of days (usually 20), calculate the range of the futures for all of the daysand also the range as a wholeand crunch these numbers into an index. |
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If the futures have not had such wild price action, the option values would certainly be less. But perhaps there is a government report due that usually causes the market to move dramatically. The option traders will want a higher premium to compensate for the risk of being short the option during the report. This extra value above the actual volatility might be called "anticipatory volatility." |
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There is another way that professional traders measure volatility, called "implied volatility." This is also a very |
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