Which Option Pricing Model Should I Use To Calculate Implied Volatility?
Posted by Pete Stolcers on March 13, 2007
Option Trading Question
I am getting so many different opinions on how volatility is calculated with the Black-Scholes model. If I am looking at an expected term of 2 years and I load the share price for the last 2 years on a weekly basis, when the volatility is calculated, it takes the standard deviation of the 104 data points times the square root of ? Is it 52 weeks (representing the weekly perspective) or is it 104 weeks representing the observation points?
Option Trading Answer
I have studied many pricing models and I am going to spare you the details. There are many who will rip my response because they make a living teaching statistics to potential option traders.
Let the Market Makers worry about the proper pricing model. They have complex auto quote systems designed by ex-NASA engineers to help them. If they are “off”, someone with a different model will “help” them get it in line by buying or selling the options.
Focus on your opinion of the stock. Nail down the direction, duration and magnitude of the move. Then, base your opinion on solid research. Input your confidence (in your analysis and the market) and you will guide yourself to a strategy. Look at a chart of the historical implied volatility of the options. If it is “in normal range”, proceed. Read it like a stock chart. Buy low, sell high. If the IV has spiked without a move in the stock - AVOID! It means there is news pending. It could be FDA approval, litigation, earnings or another event. Options allow you to tailor fit a position to match your opinion.
If you think the stock is going up in 3 months, don’t buy a LEAP. I have a number of trade examples in the blog where I go throu the process and I include the strategy.