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 Option Vega υ : A first attempt
Issued on November 18 2011 par StrategiesOptions
Implied volatility in the Black & Scholes option pricing model is supposed to be constant. It's far from reality.
I - Vega or how Black & Scholes model doesn't work out.
Black & Scholes option pricing model claims that volatility is constant. That way, tomorrow's volatility would be today's one. The same way, every strike would exhibit the same volatility, because one is able to find only a single standard deviation with a set of data. In theory, if one is fine to compute standard deviation, one would find that Implied Volatility (the volatility which makes theoritical price equal to market price) is the same as historical volatility. Hence, none would neither buy implied volatility above "real"one nor sell implied volatility below historical one. Only one volatility. Reality is often far from that. II - Some facts In real life, things are quite different. Every day prices are set in order to match supply and demand. Thus, during the same day, without any change in spot level, option prices fluctuate. There is a price dynamic. Because strike, time to maturity, spot level, interest rates remain the steady, the only factor that leads to different prices is volatility. III - Volatility impact on option prices A european call on an asset which current level is $100, no interest rate, struck at 105. With a volatility at 31% the option value is $12.37. If volatility is set to 32%, the value becomes 12.765 and if volatility is at 30%, the value reaches 11.977. We then understand the higher the volatility the higher the option value. Next : Option Vega υ Previous : Option Gamma Г OPTIONS 101 - INDEX OPTIONS 101 - CHAPTER I OPTIONS 101 - CHAPTER II OPTIONS 101 - CHAPTER III OPTIONS 101 - CHAPTER IV OPTIONS 101 - CHAPTER V OPTIONS 101 - CHAPTER VI StrategiesOptions |
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