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When I buy a share in a company, I buy a piece of the company, however small. In recent times, there is a lot of interest in trading volatility. Now my first question is: when i buy volatility (by buying an option), what exactly am I buying.

I am not asking what i am buying when i buy an option. The answer is insurance. My question is: what am I buying when I buy volatility?

  • Can you link to some source that says buying volatility is the same thing as buying an option? I haven't personally seen that written anywhere. There are many ways to profit from an option during low volatility periods, and many ways to lose money on an option during high volatility periods. – dg99 Feb 12 '15 at 19:26
  • Umm...well...long option --> long volatility...because you profit if the volatility goes up....in that sense buying option is buying volatility. not correct? – Victor123 Feb 12 '15 at 20:43
  • Hmm, no, that's not a legitimate financial concept. Holding an option on a company's stock does not mean you profit if the volatility in that company's stock increases. Volatility can increase 10000000% without the price moving more than a tick in either direction. – dg99 Feb 12 '15 at 22:00
  • If volatility increases without the underlying moving, the option value will increase, so I will profit by selling the option – Victor123 Feb 12 '15 at 22:03
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    @dg99 - Take a peek at the Black–Scholes model for options pricing. Volatility is an important part of the model. Volatility increasing 1000% will certain impact options pricing. A BS calculator will let you prove this to yourself. – JoeTaxpayer Feb 14 '15 at 16:51
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Two shares, A and B, each cost exactly 100 dollars. An expert who has never been wrong tells you: There is a 50% chance that A will go up to $101, and a 50% chance that A will drop to $99. There is also a 50% chance that B will go up to $150, and a 50% chance that B will go down to $50.

If you buy A, there is an equal chance that you make one dollar, or lose one dollar. If you buy B, there is an equal chance that you make fifty dollars, or lose fifty dollars. Buying B is just a bigger bet than buying A.

Now you buy a call option which gives you the right to buy A or B for $100. If A goes up to $101, you make one dollar. If A drops down to $99, you lose nothing (because it is an option and nobody can force you to exercise the option). So there's a 50% chance to win one dollar, and a 50% chance to win or lose nothing. That option is worth 50 cents. But if you have a call option for B, there's a 50% chance you make $50, and a 50% chance you make or lose nothing. This option is worth $25.

Normally, volatility increases your chances of winning a lot or losing a lot. With call options, volatility increases your chances of winning a lot or losing nothing.

Now look at a $110 call option. There is no chance that A will reach $110, so that option for A is worthless. But there is a good chance that B will reach and exceed $110, so the option is worth a lot of money.

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    "winning a lot or losing nothing" I'd like a deal like that, can you explain exactly how to get me some? – JoeTaxpayer Feb 9 '15 at 23:57
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    You have to make up at least the trading cost of the option purchase to "lose nothing." – Kent A. Feb 10 '15 at 0:27
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If you refer to the $VIX, the article Tracking Volatility: How The VIX Is Calculated may explain it for you in detail.

Here the main thing quoted:

Delving into the Details The VIX is calculated using a "formula to derive expected volatility by averaging the weighted prices of out-of-the-money puts and calls”. Using options that expire in 16 and 44 days, respectively, in the example below, and starting on the far left of the formula, the symbol on the left of “=” represents the number that results from the calculation of the square root of the sum of all the numbers that sit to the right multiplied by 100.

Here is another link, this time to the CBOE whitepaper about the $VIX

Of course there are more volatility tracking indices, where some may be calculated differently.

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Volatility is the "fear index". When you buy the VIX, you're buying fear in the sense that you think people are about to panic and sell shares. In 2008 this was a great trade. Volatility built into an option is the same concept except that you are paying a premium with respect to how scared people are about a specific stocks price movements.

  • You're answering with CNBC-style layman's buzzwords rather than the technical details the OP seems to need. "Volatility" is a mathematical concept, not a "fear index". The VIX is also a mathematical construct, and not a "fear index", despite whatever the media might like to call it. It's true that, empirically, volatility is higher when prices are declining, but that's not always true. – dg99 Feb 12 '15 at 19:24

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