The Role of Supply and Demand

The forces of supply and demand determine option prices, just as they determine all prices in free markets. What varies from market to market,however, is the market-determined component of price that is used to evaluate the instrument being priced. In the stock market, for example,the price-earnings ratio is used widely to make judgments about a stock’s value.

If the stock of Company A is at $80 per share with a price-earnings ratio of 10, and if the stock of Company B trades at $35 per share with a price-earnings ratio of 15, then Company A is said to be less expensive than Company B.In this context, the term less expensive means the stock with the lowest price-earnings ratio, not the lowest absolute price per share.

Price-earnings ratios make it possible to compare companies with different levels of sales, different number of shares outstanding, and different stock prices. Book value and price-to-sales and debt-to-equity ratios are other “common denominators” used by stock analysts.The price-earnings ratio, however, is market-determined because it is a function of stock price.

The earnings per share reported by auditors is known and is determined independently of the stock price. The stock price, however, is determined by supply and demand; so too,therefore, is the price-earnings ratio determined by supply and demand.In other words, the price-earnings ratio is market-determined.In the options market, implied volatility is a market-determined component of option price that makes comparisons between options possible.

Five of the inputs to the option-pricing formula are known: stock price, strike price, expiration date, interest rate, and dividend.Volatility between now and option expiration, however, is unknown.Nevertheless, given an option price, a trader can work the pricing formula backwards to find the volatility percentage that would produce the market price of the option as the theoretical value. This percentage is the implied volatility of the option.

In other words, the volatility percentage that produces the option’s market price as the theoretical value is the implied volatility. In Gary’s XYZ 70 Call, 32.84 percent is the volatility that made the formula’s calculated value equal the option’s market price.Just as the price-earnings ratio in the stock market is a common denominator that makes comparison of stock prices possible, implied volatility also facilitates comparisons of option prices.

If the options on the stock of Company A are trading at an implied volatility of 38 percent,and if the options on the stock of Company B are trading at an implied volatility of 25 percent, then it can be said that the market believes that the price of Company A’s stock will be more volatile than the price of Company B’s stock. No one can guarantee that price action between now and option expiration—realized volatility—will bear this out, but it can be said with certainty that, today, this evaluation reflects the market’s opinion.

Implied Volatility Changes: In addition to making comparisons between stocks feasible, implied volatility also makes it possible to evaluate changing conditions on one stock by comparing its volatility at different times. It is common parlance,for example, to describe Gary’s XYZ March 70 Call as trading at 32.84 percent volatility. This call, at some previous time, may have been trading at a higher or lower implied volatility.

If all other factors are equal, then an option trading at a lower implied volatility should make a relatively good purchase, and an option trading at a higher implied volatility should make a relatively better sale. Rarely, if ever,however, are all other factors equal! Therefore, the level of implied volatility cannot, in and of itself, dictate whether you should buy or sell an option.

Implied volatility is, however, important information that a trader can incorporate into the subjective decision-making process.Both Historic and Implied Volatility Change:Stock prices go through periods of high and low historic volatility. The changes may be driven by events specific to the company, such as new-product development, earnings announcements, or management turmoil, or perhaps the changes may be driven by events in the general market.

Nevertheless, option traders need to be aware of the stock’s current level of volatility in order to make a realistic forecast. If a stock’s price has not risen or fallen $10 in any month in the last two years, such a price change will not likely occur this month.However, if a monthly $10 price change happens frequently, then forecasting such a change this month would be reasonable.Implied volatility also rises and falls both because of company events and because of changes in the general market. And just as traders need to be aware of stock-price volatility, so too do they need to follow implied volatility.