VOLATILITY
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An obvious truth—to achieve success in betting a stock will
move up or down, you have to bet on stocks that are known to
move up or down. Therefore, another element that controls the
price of a listed option is the price volatility of the underlying common
stock, the amount that the stock price moves up and down.
A common stock price that has high volatility normally
moves in very wide ranges over a period of time. A volatile stock
may move from 40% to 60% off its base price annually. Such
wide price movements give it a much greater probability of moving
through the strike price of a listed option, and, as a result,
that option will take on more premium (time value).
On the other hand, a stock with low volatility normally
trades within a narrow range, not moving very far in any one direction.
This will have a negative effect on the option price because
the probability of the stock price moving through the
strike price is diminished.
However, understanding stock volatility in the options market
can be tricky. In some cases, a common stock that has been
historically quite volatile may reach periods in which it is somewhat
dormant, and, conversely, stocks that are normally quite
low in price volatility will suddenly move dramatically in one direction
or another. These shifts in price behavior will alter the influence
of this factor on the listed option.
An obvious truth—to achieve success in betting a stock will
move up or down, you have to bet on stocks that are known to
move up or down. Therefore, another element that controls the
price of a listed option is the price volatility of the underlying common
stock, the amount that the stock price moves up and down.
A common stock price that has high volatility normally
moves in very wide ranges over a period of time. A volatile stock
may move from 40% to 60% off its base price annually. Such
wide price movements give it a much greater probability of moving
through the strike price of a listed option, and, as a result,
that option will take on more premium (time value).
On the other hand, a stock with low volatility normally
trades within a narrow range, not moving very far in any one direction.
This will have a negative effect on the option price because
the probability of the stock price moving through the
strike price is diminished.
However, understanding stock volatility in the options market
can be tricky. In some cases, a common stock that has been
historically quite volatile may reach periods in which it is somewhat
dormant, and, conversely, stocks that are normally quite
low in price volatility will suddenly move dramatically in one direction
or another. These shifts in price behavior will alter the influence
of this factor on the listed option.