Revisiting the Insurance Analogy

One explanation of why implied volatility changes is based on the analogy between options and insurance presented in Chapter 3. In thatm analogy, volatility is comparable with the risk factor in insurance. The level of risk is one component in determining the level of insurance premiums.If an insurance company has a record of claims showing that one of 100 homes is destroyed by fire, for example, then, in theory, fire insurance would cost 1 percent of the value of a home plus a profit margin.

If, however, the insurance company forecasts that fire will destroy a greater percentage of homes in the future, then it will raise its premiums. Similarly, if the company perceives that fire will cause less damage, perhaps owing to fire and smoke alarms and improved building practices, then premiums are lowered.Insurance companies, however, live in a competitive environment,and some premiums are set to meet the competition.

In some market environments, the competitive level of insurance premiums will be higher than the theoretical level calculated by an insurance company.In such an environment, the market expects more risk than the history of risk as calculated by the insurance company. In other market environments, the competitive level of insurance premiums is below the theoretical level calculated by the insurance company.

In those environments, the market expects less risk than history indicates.Historic volatility is like the insurance company’s records of actual claims experience. Expected volatility is like a particular insurance company’s forecast of future claims.While it might seem desirable to sell insurance at higher premiums when the market expectation for risk is above the historic level of claims, one has to remember that markets are generally very efficient.

Frequently, prices rise before most people understand why because the market perceives something that many individuals do not see. An example of the market perceiving something was the historic rise in oil prices from 2006 to 2008 to over $140 per barrel. In the early stages,when oil was hitting new all-time highs of $40 and $50 per barrel,there were several oil market analysts who said, “Oil above $40 is a temporary phenomenon,” and then, “Oil above $50 is unwarranted by the fundamentals,” and then, “Oil above $70 simply cannot be sustained.”

In retrospect, the market clearly foresaw that supply-demand conditions had changed, whereas many individuals did not.In options, the level of implied volatility is the market’s consensus estimate of future volatility. In many cases, the market perceives a rise or fall in stock price volatility that many individuals actively involved in the market do not see. Professional traders must never forget this. They must constantly ask:

What is the market—through implied volatility—saying about future volatility? What might the market be seeing that I do not see? And how can I protect myself if what the market is saying turns out to be right and what I am thinking turns out to be wrong?Implied Volatility Can Change Intraday Implied volatility not only changes over weeks and months, Table 7-6 demonstrates how implied volatility can change within a trading day.

Column 1 shows the time of day, whereas column 2 lists the stock price.The stock price fluctuates from a low of 76.25 to a high of 77.95.Columns 3 and 4 contain the bid and ask prices of the 80 Call, and columns 5 and 6 state the implied volatilities of the bid and ask prices.At 9:30 a.m.,when the market opens, for example, the stock price is
76.25, and the 80 Call has a bid price of 2.60 and an ask price of 2.80.

The implied volatility is 31.0 percent for the bid and 32.6 percent for the ask. By itself, this information has little value. However, consider the situation at 12:30 p.m. when the stock price is up to 77.95, and the implied volatilities of the bid and ask prices have increased to 33.8 and 35.4 percent, respectively. Then consider the situation at 4 p.m., when the stock price is down to 77.40, and the implied volatilities have retreated to 31.1 and 32.7 percent, respectively.

A trader who looks at implied volatility only at the beginning and end of each day would notice little change. Only full-time traders who watch this market all day see the nearly 3 percent rise and fall in implied volatility. Of course, Table 7-6 presents only one possible pattern of implied volatility, which, like stock prices, could behave in any number of ways.Just as in forecasting stock prices, predicting changes in implied volatility is an art, not a science. Option traders must be aware of how much implied volatility can change, and they must gauge the potential impact on their positions. This topic will be discussed more in Chapter 10.