Volatility

Volatility - the measure of variation in the price of the underlier - plays a very important role in option valuation. As a rule of thumb, the higher the volatility, the more expensive any option gets. When talking about option pricing the term volatility usually means the annualized standard deviation of logarithmic returns of the base instrument.

Volatility scales with time according to the square root law. E.g., if annualized volatility is 16%, then for one year average change in the price of the contract will be 16%, for four years 32% and 8% for one quarter. Since there are approximately 256 trading days in a year and the square root of 256 is 16, average daily changes in the price of a contract are 1/16 of the annualized volatility.

You can switch to the graph view to see how the price of a put changes with a change in the volatility. As volatility goes to zero, the price of the option becomes equal the the intrinsic value, which is 0.5 in this example. You can change the base price parameter to see how this affects the option price at the same volatility level.

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The screenshot shows the following portfolio:

This is an excerpt from iOptioneer option trading reference application. In order to build the real-time dynamic strategy graph and run simulations you will need to download the application from App Store.