Register / Login

Estimating Volatility for Option Pricing

Premium

A key challenge in using either Black-Scholes-Merton or a binomial option pricing model is accurately estimating the stock's return volatility.
Two common approaches for estimating volatility:

Historical Approach: This assumes that past volatility is representative of future volatility.

For BSM, the annualized standard deviation of price returns is applied.
σannual = σperiodic * √periods per year
250 trading days per year is a convention when the periodic standard deviation is daily; 12 is applied for monthly data; 52 is applied for weekly data.

Implied Volatility Approach: This takes the current market price of the option and back solves for the implied value of volatility via the option pricing model.

The output of the implied volatility approach is an estimate for volatility that equates the BSM price of the option to the market price of the option.
Analysts and traders can use this approach to form opinions as to whether an option price is too high or too low based on their own expectations for volatility relative to the implied volatility priced into the option.

Unlock Premium Content

Upgrade your account to access the full article, downloads, and exercises.

You'll get access to:

Access complete tutorials and examples
Download source code and resources
Follow along with practical exercises
Get in-depth explanations

Previous Lesson

Dynamic Delta Hedging & Gamma Related Issues

Put-Call Parity for Options on Forwards

Derivatives Part 2

25 lessons

CFA Level 2: Derivatives Part 2 – Introduction

Introduction to Options

Synthetic Options and Rationale

One Period Binomial Option Pricing Model

Call Option Price Formula

Binomial Interest Rate Options Pricing

Black-Scholes-Merton (BSM) Option Pricing Model

Black-Scholes-Merton Model and the Greeks

Dynamic Delta Hedging & Gamma Related Issues

Estimating Volatility for Option Pricing

Put-Call Parity for Options on Forwards

Introduction to Swaps

Plain Vanilla Interest Rate Swap

Swap Pricing vs. Swap Valuing

Pricing and Valuing a Plain Vanilla Interest Rate Swap

Pricing and Valuing Currency Swaps

Pricing and Valuing Equity Swaps

Swaps as Theoretical Equivalents of Other Derivatives

Swaptions and their Valuation

Swap Credit Risk and Swap Spread

Interest Rate Derivatives - Caps and Floors

Credit Default Swaps (CDS)

Credit Derivative Trading Strategies

Topics

Related Groups

Finance Concepts