Morningstar Advisor - Spring 2008 - (Page 27) Figure B: Options allow us to split the stock price distribution into upside and downside exposure. by the expected value of the stock. If we now balance the upside of the distribution on a knife edge, the distance between the balance point and the strike price is the expected value for the upside, and therefore the option value. If we compare the wide distribution with the narrow one, we can see in figure C how the wider distribution generates a balance point further from the strike price, so the two options have different values with the same stock price. As we can see, the width of the probability distribution, or the implied volatility, can be completely independent of the actual stock price, or in portfolio management terminology, the two can be uncorrelated. In practice, implied volatility tends to be negatively cor- related with stock price, because fear and uncertainty tend to rise in declining markets. So, we have a measure that is slightly negatively correlated with underlying security price, but otherwise independent of security price. From a portfolio management perspective, uncorrelated is a good thing, and negatively correlated can be even better. However, investors can’t directly invest in implied volatility. But they can construct option positions that vary with implied volatility, and investors can purchase futures on market-level implied volatility, so implied volatility is investable, at least indirectly. ity’s status as an asset class is to understand the long-term return characteristics of implied volatility. Let’s return to our familiar graphical interpretation of volatility to understand how implied volatility compares to realized volatility, and thereby how implied volatility turns into cash flow for investors. Figure D: The longer the time period that passes, the further a stock typically moves from its current price. Figure C: The wider the probability distributions, the more valuable the options. Implied Versus Realized Volatility Another aspect of evaluating implied volatil- As most investors know from experience, the longer the time period that passes, the further a stock can typically be expected to move away from its current price as shown in figure D. Because an option has a longer time period to expiration, the probability distribution gets wider, and therefore, the upside and downside MorningstarAdvisor.com 27 http://MorningstarAdvisor.com
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