Using Options to Gauge Future Volatility

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The prices of options on the Nasdaq-100 index (ticker NDX) express expectations for movement over time – otherwise called volatility.  The higher NDX option prices are the more future volatility option buyers are expecting – or fearful of and trying to hedge against.  If NDX option price are lower then the market expects less future volatility.

But the math of option pricing and volatility can be daunting.  Is there an easy way to determine the market’s estimate for volatility of the Nasdaq-100 index based on NDX option prices? There is indeed a simple way and it requires only basic arithmetic and can be very useful whenever gauging the market’s expectations of volatility for any asset. 

Speculative buyers of call options need the underlying asset, the Nasdaq-100 index in our example, to rally in order for the call options to be profitable at option expiration.  Speculative buyers of put options need the underlying asset to fall in order for the put options to be profitable at option expiration.  If they don’t believe the Nasdaq-100 index will rally enough or fall enough to make their trade profitable they won’t buy the options to begin with.  So the price the market is willing to pay for options tells us how much volatility the market expects. 

For example, at the close of trading on Wednesday, December 5, 2019, the Nasdaq-100 was at 8296.53.  You could buy the NDX 8300 strike call option expiring on January 3, 2020 for 154.00 at the close.  The buyer of that call option needs the Nasdaq-100 to rally to 8454.00 (the 8300 strike price plus the 154.00 paid for the call option) in order for the call option to break even at expiration.  That would be a rally of 1.90 percent.

You could buy the NDX 8290 strike put option with the same expiration for 148.00 on the close.  The buyer of that put option needs the Nasdaq-100 to fall to 8142.00 (8290 minus 148.00) in order to break even at expiration.  That would be a drop of 1.86 percent. 

Those call option buyers believe the Nasdaq-100 index is going to rally to at least 8454.00; those put option buyers believe the Nasdaq-100 index is going to fall to at least 8142.00.  That range up and down, a range of 3.76 percent, expresses how much volatility the option market expects from the Nasdaq-100 index from yesterday’s close to the option expiration on January 3, 2020.  The NDX option market believes the Nasdaq-100 index will trade within a 3.76 percent range between now and option expiration on January 3.

That is the amount of volatility the NDX option market is predicting. 

Is that a lot or a little?  When doing this analysis you have to take the historical moves of the Nasdaq-100 over this sort of 29 day period into account but there are some things to keep in mind.  First, investors will get nonfarm payroll data before the open on Friday.  That is usually the most consequential economic data of the month and often generates substantial volatility.  There is also the potential for volatility before the end of the year.

This sort of analysis can be done on any asset with options by using the prices of the options closest to at-the-money and doing this same arithmetic. 

Catalysts like economic data are an important element of option pricing and will impact this expected range.  For example, Adobe (ticker ADBE) is a member of the Nasdaq-100 index and is due to report earnings after the close on December 12.  What sort of volatility does the option market expect for Adobe between now and option expiration on January 3?

Adobe closed at 302.51 on Wednesday and the 302.50 strike put option could have been bought for 8.70.  Any speculative buyer of that put option would need Adobe to be at 293.80 at option expiration in order to break even.  That would require a move of 2.88 percent.

Similarly, the 302.50 strike call option could have been bought for 9.10.  That would require a move to 311.60 for the buyer of the call option to break even.  That would be a move of 3.00 percent.  So the option market expects Adobe will experience a range of 5.88 percent between Wednesday’s close and option expiration on January 3.  This includes that earnings announcement which injects substantial uncertainty, hence the higher expected volatility.

This is a quick way to use option prices to understand the volatility expected for any stock or index – and it is easy to calculate and understand.  The measure will change over time, increasing as uncertainty increases and decreasing when traders and investors feel they have less to worry about.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Scott Nations

President of Nations Indexes: Scott Nations is the President of Nations Indexes and a bestselling author. Scott is also a Contributor to CNBC and regularly appears on-air to discuss markets, current economic events, and the outlook for a variety of financial vehicles. Nations Indexes is the world’s leading independent developer of volatility and option enhanced indexes and investment vehicles. The Nations Strategy Indexes, including the Nations NDX PutWrite Index, combine index investing and systematic option strategies to generate superior absolute and/or risk-adjusted return over full market cycles. The Nations Better Beta® Indexes are the first indexes which magnify gains without magnifying losses.
Scott is also the developer of the Nations suite of volatility indexes including VolDex® (ticker symbol VOLI) and TailDex® (ticker symbol TDEX), the first measure of the market’s expectations for a “tail event” or steep drop in prices.
Scott is the author of A History of the United States in Five Crashes, a general interest history of the five modern stock market crashes (1907, 1929,1987, 2008 and the Flash of 2010) which was published by HarperCollins in June 2017. Scott is the author of Options Math for Traders, published by Wiley & Sons in 2012 which was an Amazon.com bestseller. He is also the author of The Complete Book of Option Spreads and Combinations, published by Wiley & Sons in October 2014. Prior to founding Nations Indexes, Scott was a member of the Chicago Mercantile Exchange and was a market maker and floor manager for a leading index option trading firm. While there, he was responsible for development and implementation of proprietary option pricing models.

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