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CALCULATING IMPLIED VOLATILITY

Options let you trade volatility directly.  Thus, the following two questions are directly related:

What is the value of an IBM option?

What is the volatility implied from an IBM option price?

In this lesson we start with the current option price and work backwards to answer the second question.

Question:  How do I calculate the implied volatility for IBM from an "at-the-money" option using current option prices?

To calculate implied volatility we need the following inputs:

i.  The underlying asset's current price (i.e., IBM's stock price)

ii.  The option's strike price

iii.  The option's maturity date (the date the option expires)

iv.  The option's current price

v.   The risk free rate of interest

vi.  The dividend yield for the underlying asset

By completing the following steps using the Option Calculator beside this lesson, you can get this data as follows.

To get i. leave the underlying ticker symbol as IBM or overwrite with IBM if this has been changed.  Next click on the button Get Stock Quote.  You will observe that the source web site (i.e., CBOE) comes up in the bottom right hand segment of your screen and the data is extracted automatically for you.

To get ii. enter the option's Strike Price to approximately equal IBM's current stock price.  This must be in intervals of 5 (i.e., 95, 100, 105, etc.,) which is why it will only approximately equal the current stock price.

To get iii. look in the drop down box with the month's listed, then select the month in which you would like your option to mature.   If in doubt about valid maturities select one month later than the current month by clicking on the month.  The Option Calculator to the left will automatically compute the appropriate time to maturity for this option for you!   To do this it is important that you complete step iv. below before the calculator is updated for maturity.

To get iv. first check that you have selected either a Put or a Call whichever is desired (i.e., call gives you the right to buy IBM at the strike price during the option's life and put gives you the right to sell).  Finally, enter IBM beside the Option Symbol box and then click on the button Get Option Quote.

By hitting Get Option Quote, the latest put or call price (which ever was selected) is automatically retrieved for you and entered into Market Option Price.

To get v. select from the drop down menu (in the bottom input box) the first URL, Bloomberg's treasury.html and then double click on it.  You will observe the yield curve for US treasuries.  Enter the yield for the closest maturity on this yield curve to the box indicating Interest Rate (e.g., if the option matures in 1 month, copy the yield for 3 months because it is the closest duration of time and therefore the closest maturity).

Finally, to get vi. select from the drop down menu Yahoo's finance page.  Then enter IBM in the box titled Get Quotes and change basic to Detailed from the drop down menu beside this box on Yahoo's site.  You will now see under Yield the Dividend Yield for IBM.

This has now completed all input requirements for the IBM option.

Final Checklist

Check that you have selected American for IBM stock options.  Virtually all stock options in the US are of the American style (i.e., can be exercised on any day during the life of the option).

Click little box beside Implied Volatility in the calculator to indicate that you want this computed.

Calculating Implied Volatility

You can now click on the button Calculate to see the Implied Volatility for your IBM option expressed on an annualized basis.  This number will appear next to the Calculate button.  You can compare the implied volatility for IBM with some other stock by repeating the above steps for another stock.

Forming a Volatility View

In a later lesson you will see that option prices increase with volatility.  Thus, options let you trade a volatility view.  Subsequent lessons will let you learn how you can apply this information.

OS Financial Trading System, PO Box 11356, Pittsburgh, PA 15238 USA, Phone 1-800-967-9897, Fax 1-412-967-5958, Email fts@ftsweb.com,

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