HardAssetsInvestor

Written by Brad Zigler  |

October 14, 2009

Clues From The Options Market

Details

What does the options market reveal about market volatility?

• The options-insurance connection
• Vega and MOO
• Historic vs. implied volatility

 

Many investors dismiss options trading as too arcane or speculative. While I can't say I blame them for thinking the business is mind-boggling, what with its use of Greek alphabetics like delta and gamma, it's not always about speculation. In fact, options are often used to reduce the risk of holding investment positions. Options are, in this sense, a form of insurance.

There's more than just a casual conceptual connection between options and insurance. In fact, your home and auto insurance policies are priced in the same manner as option market makers set their premiums.

Can't see the connection? Just think about the similarities between options and insurance:

• Term - Each contract provides a benefit to the holder only for a specified time period;
• Strike Price - A home or auto policy effectively grants the owner the right to "put" the subject property to the insurer at a specific price in the event of a total loss, just as a put option affords its holder the right to sell the underlying asset to the grantor at a predetermined exercise price;
• Premium - To obtain each contract's benefits, the holder must pay a risk-based fee to the seller.

It's setting that risk-based premium that involves all "the Greeks," as those parameters are known on the trading floor. Among the most important of the first-order metrics is vega (which, oddly enough, isn't a Greek letter at all). Vega is a measure of volatility, representing the dollar-per-shift in an option's value, as expected for each 1 percent change in the underlying asset's variance.

Too arcane? Let's look at a practical example to clarify things.

Right now, with the underlying Market Vectors Agribusiness Fund (NYSE Arca: MOO) trading at $39.42, November $40 calls are offered at $1.40 per share. If you dissect the premium with an options pricing model, you'd find embedded in that offer an assumption of annualized volatility—otherwise known as implied volatility—of 32.5 percent. Simply put, that's the degree to which the fund's share prices are expected to vary around their mean over the call's remaining life.

This volatility assumption translates to a vega coefficient of 0.05, which means that, holding everything else constant, you'd expect the call premium to increase by a nickel a share if the fund's price volatility increases by 1 percent (and to likewise decrease $0.05 if the volatility drops the same amount).

So if the market maker expects the standard deviation in MOO's daily returns to be 33.5 percent, you'd likely see the offer raised to $1.45 a share. Conversely, an expected risk of 31.5 percent would engender a $1.35 asking price.

At this point, you may be saying to yourself, "So what? I don't want to trade options." Well, that may indeed be the case, but it doesn't mean you can't make some friends in the options market. Sometimes, market makers can be a stock or fund trader's best buddy.

To fully appreciate this camaraderie, you need to make a distinction between implied volatility and historic, or statistical, volatility.