Dear Mr.Ghosh,
Can you kindly guide me to the basics of understanding the impact of volatility on option pricing? I posted the same request on the board and no replies so far. I tried searching but could not locate thr relevant posts. That is why I started this new thread. Thank you.
Dear huineng,
This is a vast topic.
Lets take an example of the relationship between index futures and index options prices in India.
Option premium is constituted of 2 price components, intrinsic value and time value. Intrinsic value contains implied volatility of the option, rate of interest and strike price. Time value is the price difference between option premiums and intrinsic value.
Implied volatility plays a key role in deciding the option premiums. Volatility is the relative rate at which price of a security changes, moves up or down. If the implied volatility rises, both call option and put option premiums will increase. If the implied volatility declines the option premiums will fall. So it is important for an option trader to understand the implied volatility and its impact on option premiums.
In a bearish market the implied volatility tend to remain very high. In a bull market implied volatility remains low. Different strike prices of a Nifty/stock have different implied volatility.
We option traders buy or write options depending on our future view of the stock or index. Whether you are planning to buy a put or call option, it pays to know more than just the impact of a move of the underlying on your option's price. Often option prices seem to have a life of their own even when markets move as anticipated. A closer look, however, reveals that a change in implied volatility is usually the culprit.
Normally we see the increase of implied volatility on stock option near the qtrly result of a stock. And at the Qtr. result day the impact volatility falls suddenly. Therefore its always recommended to exit from stock option atleast 1 day before the Qtr result.
Many options traders even if they create long straddle on the expectation of quarterly numbers, by buying call option and put option of a stock with same strike price and maturity, end up in huge loss due to decline in implied volatility.
Fresh option buyers who would like to take positions on the day of the quarterly result or any special news should postpone their purchase or buy it only after the quarterly number will help them to reduce the losses. The same rule is also applied for budget/special policy announcement also. Buying options prior to the budget or after the announcement of budget/special policy announcement is the one of the best things to do. Never buy options during the budget session, preferably one can buy long straddle five day prior to budget and exit before the budget, or buy option (call or put) after the announcement of the budget.
Hope above helps.
Regards
