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Different Volatility on Different Stocks
Volatility not only affects the price of an option, it can also have an effect on other trading decisions that a person makes as well. Let’s say for instance that a person is deciding between two different stocks to purchase that are pretty much trading at the same price. Let us say that you have decided to buy call options on each one of these; however you are not sure about which is going to be the most profitable. Obviously, it is impossible to know exactly how the trade will turn out in the end; nonetheless there is a way in which you can at least get a head start on the game from the outset. So, during your study of both these stocks, you suddenly find to your shock that same call option on each of the stocks is trading at quite different price levels from each other. So how is this possible though? If both stocks area at an equal price, and you are able to see the same strike price, and both of them have the same expiration date. What is going on? This is what we know as volatility. Just to show that volatility does have a big part when it comes to the prices of options, we will check an example of two different stocks that have pretty much the exact same price and their equivalent option chains. We are going to have XYZ and RIP as the two prospects we are looking into buying. Both of these are trading at $42.82 on the 29th of March. You are looking into getting a call option since you are bullish. We will choose the $45 calls for the month of May, you are going to compare the prices of options, and look into the profits you could obtain from it. Keep in mind that there are a few different determinants when it comes to the price of stock options, these include: the price of the underlying stock; the strike price of the option; the time to expiration; volatility; the interest rates; and finally the dividends. So if both of the stocks are trading at almost price which is 42.83 and $42.83, the strike prices would be the same, a $45 call, and the options have the same exact expiration time. The dividends and interest rates are so small in the picture that they cannot be the reason why there would have to be such a big difference in the call price they are offered at, which we will say that XYZ’s $45 call is offered at $2.70 ask price whereas RIP’s $45 call is being offered at $0.30 ask price. Why is there such a huge difference here? The only thing that could be causing this difference is volatility.