Expected, or implied, volatility is the primary factor underlying the price of options for equities, futures and any contract in which the holder has the right to buy or sell at a fixed price over a specified time period an underlying asset or liability whose price is free to vary. Traders in the options market determine implied volatility based on the fluctuation of the underlying price — including historical price movements and expected future variations.
Based on the assessment of volatility, the options market sets an upper and lower price range for the underlying through the expiration date. On “Wells Fargo calls,” an option price is computed for each of nine strike prices, with the underlying stock at $43.23. Upper and lower prices are breakeven stock prices at the January 2014 expiation date that result in zero gain or loss from a delta-neutral trade on Aug. 9 (hedging the number of options sold short determined by the inverse of the slope at a specific strike against a long position in the underlying stock).
“Wells Fargo price curve” (below) shows the dynamics of pricing a call for which the strike price is equal to the stock price. A line tangent to the option’s price curve has a slope equal to 0.575. The upper breakeven price occurs where the sloped line intersects the horizontal axis at $48.207. The lower breakeven price is $39.558, directly beneath the intersection of the sloped line and the intrinsic value line, on which each point equals the stock price less the $43.23 strike price. The sloped line on the chart is lowered slightly to make it easier to see the details.
The height of the option price curve where the stock equals the strike price can be used as a measure of relative volatility. “Four equities” (below) shows volatilities compared for Facebook, Google, Starbucks and Deere.
The heights along the curves equal the ratio of call price-to-strike price, with the primary comparison made where the ratio of stock price-to-strike price equals 1.0. It is easy to see that Facebook is far above the other three equities in terms of implied volatility, roughly twice the height of either Google or Deere. The volatility measure for Facebook January 2014 calls is approximately the same as that for Deere’s January 2015 options, equalizing the time value of 16 months for Deere with four months for Facebook.