How exactly does Volatility effect option prices?

by Derek Moore on February 4th, 2014

After two years of relative calm, volatility has once again returned to the forefront of market discussions. You hear about how the VIX has spiked to above 20 for the first time since the government crisis in October. You hear the commentators talk about large institutions putting on insurance through puts. But what exactly does higher volatility mean to options pricing?

Back in mid January (1/12/14) we saw the VIX at 12.14. Today (2/3/14) around 2 PM eastern time the VIX spiked to 20.56. Yes you’ve heard people talk about how higher volatility means options prices become more expensive. But just how expensive?

We took a look at some sample options, both puts and calls from these two dates. The 5 delta strikes were used which would have about a 95% probability of expiring worthless. Where multiple strikes shared a 5 delta, we picked the ones furthest from the money. Both month’s options have 39 days until expiration.

Both the calls and puts each gained. In fact the puts are 45.8% more expensive. The calls $31.24%.  Another interesting observation is the distance from the SPX index to the 5 delta strikes. In January, 92 points between the 1930 call strike and the underlying vs. 125 points for February. 188 points separated the puts in January vs. 270 points currently. To put another way, you are getting paid more as an option seller despite the fact that your options are further away from the money.

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