Implied volatility: a decision-making tool

If the Stock Exchange of Thailand (SET) 50 Index stands at 613 points, then the at-the-money level is 610 points, the minimum in-the-money level is 470 and the maximum out-of-the-money level is 730 points.

Option premiums (two-month maturity) start from 0.1-130 points (Bt20 to Bt26,000). The question is how to choose the best option.

Before answering this, we must analyse the different considerations in addition to the premiums, which have different strike prices.

If we think the SET 50 Index will rise to 650 points, or by 37 points within one month, we should buy "long call" options, because the premiums vary depending on when an option matures.

In-the-money call options will have the highest premiums. For instance, if S50M08C470 rises 36 points, the value will decrease, because the strike price will be higher.

The difference is in line with premiums to be paid when the order is executed. Given thatn-the-money call options are the most expensive, the price increase is also the highest.

Considering returns on investment, call options that are close to the at-the-money level will have the highest value. For instance, S50M08C600 has a 47-per-cent rate of return, while S50M08C560 and S50M08C660 have rates of return of 43 per cent and 32 per cent, respectively. However, call options offering the highest rate of return will depend on your anticipation of the level of the index.

If we expect the index to be at 620, 670 or 729 points on the execution date, call options providing the highest rates of return are 610, 630 and 650 points, respectively.

To receive the highest rate of return, we should buy in-the-money call options but below the level forecast for the index.

If our guess is wrong, and the SET 50 Index drops below what we expected, we would lose the entire amount of premiums paid, because we would simply let the options expire. Buying options with a lower strike price is a better choice than buying options offering the highest rate of return. We will receive less profit but not lose if the SET 50 Index is at a lower-than-expected level on the execution date.

A lower strike price will have a lower break-even point, and thus we will have less risk of recording a loss. Buying options is a trade-off between the rate of return and the break-even point.

Therefore, the risk tolerance of each investor is the main factor in making a decision to buy options.

Another method gaining popularity abroad in deciding which options should be bought (price may not be the lowest) or sold is the Black-Scholes model.

Under this method, six factors that affect option prices are underlying assets (in this case, it is the SET 50 Index), strike price, interest rate, dividend pay-out ratio, duration remaining until maturity and SET 50 Index's volatility.

Future index volatility is the most difficult factor to predict, because it is only an anticipated figure. The Black-Scholes method consists of two parts.

The first is that if we think annual volatility will be 30 per cent, we can use this figure to work out the theoretical price of options. These will be used as benchmarks to decide whether options are cheap (the market price is lower than the theoretical price) or expensive (the market price is higher than the theoretical price).

Since volatility is the most influential factor, being wrong in our anticipation of volatility will lead to incorrect theoretical prices. That is why this is not such a popular choice.

The second part of the method is implied volatility. This is a way to calculate index volatility that is aimed at making the theoretical prices equal to the market prices.

If the implied volatility is high, it indicates that options are expensive. On the contrary, if the implied volatility is low, it suggests that options are cheap.

Should we correctly forecast the SET 50 Index point level for the date our options mature, we can turn good profits from buying options offering the highest rate of return. However, it is very difficult to estimate the SET 50 Index's level, so adopting the implied-volatility method may be a good choice.

Buying options should also take other factors into account, such as trading liquidity, as it has a big effect on option prices, and we will talk about the issue in the next article.

This article was contributed by the Trinity Group.