Implied volatility refers to the relation of the option price of a stock to the stock price itself. Calculating implied volatility relies on an equation known as the Black-Scholes formula, and it is not figured by hand. It is normally part of a regression time-series program for measuring the standard deviations of the option's price as the underlying stock's price shifts. This change in the option price is at the root of making money from a straddle, or a bet on increased future volatility.
1. Research the historical changes of the option prices on the asset in question. This information can be easily retrieved by your broker. Making money in straddles requires a shift in the option’s price that will permit you to sell the option for more than you paid for it. A straddle is done "at the money," meaning just as the option can actually be used. Each option has a "strike price" that dictates the value of the stock before the option can be used. In other words, in order for the option to be used, the stock must have already reached the strike. A straddle is a method where an investor buys a put and a call option – options to both buy and sell – hoping that any increase in volatility will cover the cost of buying the two options as well as provide a profit.
2. Run the regression time-series software with the following variables: the option price, strike price, the expiration date of the option, the interest rate, the price of the stock itself, and the dividend yield of the stock. The purpose is to figure out the "delta value" – the change in the price of the option as the underlying asset's value changes. This is how a straddle can be profitable. For example, whenever a certain stock goes up by $1, the price of the option goes up 50 cents and the delta is .5. If you buy the call and put options for 10 cents, and the stock moves by $1, you can sell the options for 50 cents and you are left with a profit of 30 cents.
3. Buy both put and call options on the stock or asset in question. Straddles utilize both, because there is no guarantee of a specific price direction and only an educated guess that the stock will suddenly move quickly. When it does, the options that you hold become very valuable. You buy at the money because the option must be ready to use right now. If the stock's delta value is high, then the chances you’ll make money are equally high. If the stock becomes volatile quickly, the option price will go up.
- Regression is a must. Most option traders continually run time-series analyses to measure relative changes over time. This is a complex equation and cannot be calculated by hand.
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