The buyer pays the premium so that he or she has the "option" or the choice to exercise or allow the option to expire worthless.Premiums are priced per share. Obviously, just the reverse of high IV and low historical volatility can be seen at different times, which would represent the opposite option price valuation conditions.
For example, the premium on an IBM option with a strike price of $205 might be quoted as $5.50, as shown in Figure 1. When IV is greater than historical volatility, options are thought to be overvalued, and when IV is less than historical volatility, options are considered to be undervalued. Since equity option contracts are based on 100 stock shares, this particular contract would cost the buyer $5.50 X 100, or $550 dollars.
As the chart shows, the two levels of volatility can oscillate around each other at certain times, and can remain at different levels for extended periods before crossing again.
The buyer pays the premium whether or not the option is exercised and the premium is non-refundable. The charts present a 20-day exponential moving average of current volatility levels, which smooths (or dampens) daily noise.
The chart shows historical volatility and IV between June 2003 and August 2007 for Altria Group Inc. A chart with a period of 60 minutes and a span of three days, for example, will plot price activity every 60 minutes (during regular market hours) and will go back three trading days.Add technical studies, if desired, using the chart's Studies menu.
Historical volatility represents the actual volatility of the underlying stock, while the IV plot represents the volatility that is implied by the market price of the options trading on MO. When they are the same or close to the same, this means that the actual options prices are implying a volatility level that is close to the same as the volatility of the underlying stock. Options MispricingIf actual prices for options are greater than historical volatility modeled theoretical prices, IV will pick up this mispricing. Customizing a ChartMany chart settings can be defined and customized by opening the Chart Setup window. Option traders apply these factors to mathematical models to help determine what an option should be worth. The mispricing can be above or below theoretical prices, which is perhaps the easiest way to understand overvalued options (above theoretical) and undervalued options (below theoretical) pricing.
To open this window, right-click on a chart and select "Chart Settings" from the drop-down menu, as shown in Figure 16.
Looking at Figure 7 again, when IV < historical volatility (options prices are undervalued as indicated with arrows in the early 2004 period with a spike up in historical volatility), we have a situation that would lend itself to a buying strategy because you can buy options at a theoretical discount. Each of these can also be defined when opening a chart (discussed in the "Creating a Chart" section of this tutorial).
With the right options strategy, it might be possible, therefore, to trade a return of volatility to normal levels, which seems to happen at regular intervals.
But to add even more volatility edge, this rule should be combined with an analysis of how expensive or cheap options are at the same time.Figure 8 provides a summary of the ideal conditions for selling and buying options.
For example, the Chart, Axis, Grid and Gradient colors can be selected under the Chart Color section of the Settings tab.
To change a color, click on the color box next to the item to be customized (such as the Chart background color; shown in Figure 17), and make a selection from the available colors.
If the Chart Type Candlestick has been selected, for example, users can make color selections for the Bar Color (the outline of the candlestick), Up bars (where price closes above the open) and Down bars (where price closes below the open).
Highlight the Study to reveal options on the right-hand side of the window for adjusting the Study's inputs and appearance.
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