Financial Markets Book Financial Markets For The Rest Of Us
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
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by Robert Hashemian

Page 326

sensitive to their underlying stock's volatility (level of price swings, usually expressed in percentages), and therefore a volatility analysis could be of immense value to many options traders. Using a chart showing the stock's volatility during the past periods, such as past few weeks or months, we would arrive at the historical volatility for that stock which can be used to forecast what the future volatility might be. Of course, future volatility can never be truly predicted. If it could, we all would be rich beyond our dreams from trading options. However, any number of things could easily throw a monkey wrench into our forecast. So it may be more accurate to refer to this volatility forecast as "expected volatility."

There is yet another side to this equation known as the "implied volatility," and that can be arrived at by inspecting an option's premium. The implied volatility of a stock is actually what determines the premium of an option, and it is based on what the market as a whole considers it to be. The higher an option's premium, the higher its implied volatility. Based on your expected volatility you may arrive at a different premium for that option (sort of like what that option's premium ought to be) because your expected volatility is different than the option's implied volatility. Now comparing your expected premium to the actual premium, you could determine whether an option's premium is over-valued, under-valued, or right on (not unlike using the PEG ratio for stocks). The problem of course is that depending on how one reads and analyzes the charts and factors in other data, no two expected volatilities may be the same. My perception of the expected volatility for a certain stock may be quite different than yours. Only time would tell which one was the correct version, or if they were both wrong.

One measure of implied volatility used by some index options traders is the CBOE Volatility Index (VIX). It measures the average

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Copyright and Disclaimer
Book Chapters
Table of Contents Copyright and Disclaimer Foreword Money
Bonds Futures Stocks Options
Mutual Funds Retirement Final Words Appendix A

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