Volatility and Options Pricing

When creating the CFA exam, there’s a natural tendency to simplify so that participants from different backgrounds can all gain an understanding of multiple areas of finance. The process allows one to understand currency impacts to earnings, modified duration, and options pricing before you even get to your first cup of coffee.

However, professionals working with each of the above concepts could outline the strengths and weaknesses of these concepts for the entirety of the 8-hour exam. In the context of the exam, though, each concept has to be broken down to a level where it can be combined with 200 other concepts so that test takers demonstrate a comprehensive understanding across all areas. I think it’s impossible to sufficiently cover all the material fully when attempting to cover so much. Neither the exam giver nor the exam taker is set up for long-term success.

Going Deeper with Equity Options

Here, I’m going to go in depth into my area of work with equity options. The goal will be to tackle concepts around derivatives:

• Volatility versus other drivers of prices

• European versus American (which one is best)

• Predictions of volatility

• Skew and why the market can’t be efficient

• What time means when we are in a quarter-by-quarter market

By background and training, I’m an engineer—so when I joined the finance world, I decided to apply math and modeling skills to the markets with the hope that there were insights to be gained. After 20-plus years, I can now say there are too many variables affecting the path to sufficiently describe the future with any degree of confidence. This may sound defeatist, but I think it sets you up for success!  Understanding that you will not arrive at a perfect description allows you to enjoy any precision that you do achieve.

Black-Scholes

When studying for the CFA exam, we discussed how the Black-Scholes model determined the price for a European option with no dividend. The following factors influenced the price and the relationship had to be understood.

he mother of all these variables is the volatility, which typically is the hardest to estimate. What I find most interesting now is the concept of multiple variable changes. Which affects prices first: increasing interest rates or volatility? Is it sequential? When the Fed increases interest rates, does the market decline and volatility follow? It could be argued that volatility rises in anticipation of rates and the higher rate is priced in before it happens. In this case, the rising rates could come with a statement of reassurance and the rates could go back down!

We are operating in a new paradigm for markets and thus for instruments like options that derive their value from market instruments. The journey gets a little less academic and a little more complicated.  We are being influenced by macro factors related to central bankers and governments. When looking at the volatility for the S&P 500, the VIX index has told a fairly tranquil tail in a challenging time.

Expectation and Reality

The Brexit vote caused volatility to stir up in late spring 2016, but after the removal of a large economy from the Eurozone, the volatility went to levels seen before the vote occurred. So the market had a higher level of volatility when it knew the British were leaving and it dropped when the talk of separation became a reality.  

In a similar vein, volatility rose before the US election on November 8, 2016, as it worried about a Clinton presidency. When the largest upset in modern politics occurred, the market got less volatile. There would seem to be a discontinuity here which skilled market participants could take advantage of.

When looking at the drivers of prices in the recent environment, having interest rates near zero has been a weak influence. Time influences options prices through the interest rates, so the lack of interest rate effect will lessen time to expiration. The stock price is a natural factor, so the unusual periods of sub-1% moves without a correction goes against the assumption of normality for returns.  

While many believe that returns are skewed positive, the pricing model assumes equal areas for the positive and negative returns. These conditions place most of the responsibility for determining options prices on the volatility. In a new world order, the purchase of volatility looks cheap versus historical levels, while the selling of volatility looks less effective. As more participants take advantage of this anomaly, there is some hope for normal levels to come back.  

So when we look at prices, understanding where the model could have conditions that are not normal can lead directional changes.

About the Author

As SunTrust Advisory Services, Inc.’s Director, Equity Derivatives, and Senior Vice President, Steve Davenport is responsible for delivering options strategies for SunTrust’s high-net-worth and institutional clients. He has a strong background in quantitative analysis and takes a sophisticated approach to asset allocation and the use of derivatives.

Steve began his investment career at State Street Global Advisors and later joined Columbia Management Advisors in Boston as a senior investment advisor. For nine years prior to joining SunTrust, Steve was the director of risk management at Wilmington Trust.

Steve holds an MS in Finance from Boston College’s Wallace Carroll School of Management as well as bachelor’s degrees in industrial engineering and mathematics/computer science from Columbia University and Providence College, respectively. Steve holds the Chartered Financial Analyst designation; he is a board member for the Atlanta Society of Finance and Investment Professionals and president of ASFIP Foundation.