by Tom Doan
In the Snider Investment Method, we sell options for a premium, which is the amount we receive for selling someone the right to purchase our shares at a particular price over a given period of time. This is the second of a series, with each article explaining a different component that helps determine the premium of a stock option. The last article discussed time and how the Snider Method uses the time value to its advantage. Today’s focus will be on volatility, another important factor that determines option premium.
As a stock price fluctuates up and down, the extremity of these movements is known as volatility. A stock with a higher volatility can have its stock price spread out over a larger range of values than a stock with a lower volatility. There are also different types of volatility: historical volatility and implied volatility. Historical volatility is the degree which a stock price has varied in the past while implied volatility is the estimated volatility of a security’s price in the future. Although historical volatility is important, option premiums are based off the stock’s implied volatility.
For example, say you have two positions in UVW and XYZ and as of today both are priced at $20 and tomorrow UVW will either be at $19 or $21 and XYZ will either be at $17.50 or $22.50. XYZ has a higher implied volatility because it has greater uncertainty and a larger range of potential prices. Because of the wider range of prices, the option premium will be higher for a volatile stock than a less volatile stock. Investor “A “may be bullish and decide to buy calls on UVW and XYZ and Investor “B“ may be bearish, thus selling UVW and XYZ calls. However, since XYZ has a higher degree of uncertainty to the direction and extremity of the price for XYZ, Investor “A” will be paying more for the call options and Investor “B” will be receiving more in option premium for the XYZ position.
The Snider Method is designed to take advantage of volatile stocks by reaping the higher option premiums those positions generate while simultaneously managing risk. The Snider Method incorporates measures such as the Band Rule, purchase Level, diversification, and screens in Lattco to help mitigate the risks associated with volatility. With these measures in place, the Snider Method utilizes the time and volatility factors in option premiums.
UP NEXT: Underlying Stock Price and an Intro to the Greeks.