Implied Volatility: The Impact of Beta on Your Option Positions
By Mark Whistler, Contributing Editor
Tuesday, September 27, 2005: Issue #245
If only we could predict emotional reactions of people in stressful situations – life would be so much easier.
Just imagine if people had volatility meters… something like a little number on their chest that alerted you to the way they generally react to conditions. A volatility reading of “1″ would indicate the person is rational. Anything below hints that they are very mellow, while a number above 1 alludes to the fact that the person you’re dealing with generally overreacts in any situation.
Your Uncle John would probably have a volatility reading of 1.5, indicating that he generally reacts excessively to any given situation by 50%. He’s tough to go anywhere with. Aunt Peggy has a volatility number of 0.5. She’s half-interested in anything you say. Sometimes you wonder if she even has a pulse.
Though in reality we don’t have volatility numbers for our families, we do have a volatility number for stocks – and it’s called implied volatility or beta. Today I’m going to explain exactly how to use the beta coefficient as a volatility meter… and how to then use that volatility meter to greatly improve your chances of making money at options. Let’s get right to it…
Beta’s Relationship to the S&P 500
Beta is a statistic that measures an underlying stock’s volatility (risk) in relation to the broad market. It tells us if a stock is more volatile or less volatile than the S&P 500.
- If a stock has a beta of 1, its price moves as much as the S&P.
- A beta greater than 1 means a stock is more volatile than the S&P.
- A beta below 1 implies less volatility.
It’s really very simple. If a stock has a beta of 1.5, than it’s 50% more volatile than the S&P on any given day. If a stock has a beta of 0.50, it is 50% less volatile.
(It’s very important to note that while beta attempts to predict a stock’s volatility in relation to the S&P 500, it doesn’t ALWAYS do so. By this, I mean that even if a stock has a beta of 1.5, it won’t always move 50% more than the S&P.)
In general, safer, slower stocks like utilities have lower betas – usually less than 1. More risky equities though, like Internet stocks, have betas greater than 1.
Pay Less for Options Using Beta
So how can beta help in options trading?
First, remember that beta is a measurement of volatility. When volatility is low, premiums are also mundane. But when volatility is high, options cost more. Why? Higher volatility means there is more risk that the option will be exercised. Thus, the writer of the option will generally demand additional premium for the risk he is taking on.
In the Black-Scholes Model, volatility is measured as the annual standard deviation of the stock price, otherwise known as “statistical volatility” – don’t get it confused with beta.
Beta is “implied volatility,” meaning it is volatility in relation to the current market consensus of the stock, and can be specifically insightful when it comes to “at-the-money” options. If you’re thinking about purchasing an at-the-money option, and the premium is excessively high, more than likely, the stock has a high beta.
So in flat markets, if you have significant insight into a stock, and are fairly sure of its movement before expiration (and the stock has a low beta), you’ve probably found a particularly tasty position, because you will generally pay less in premium.
Watch Out for Low Betas…
Of course, a lower beta indicates more risk, as the underlying stock will most likely not have any dramatic moves. You should be certain of your reason for implementing the position before making any transactions.
In addition, if you implement a position in a LEAPS with a low underlying beta – and you are SURE (read: you’ve done your research) the stock will slowly hit its strike several years out, you’ve probably made a good decision, as the premium will most likely be low.
Remember that beta is a measurement of an underlying stock’s implied volatility and gives you insight into a stock’s potential volatility.
Simply put, you wouldn’t want to buy a short-term, deep out-of-the-money option where the underlying stock has a low beta. While the option would certainly be cheap, the stock would probably never move enough to make your option position worth anything.