Can you explain implied volatility, and why is it so important for warrant investors?

Volatility can be defined as the amount of variability in the returns of a particular asset (eg. a share price). Another way to look at volatility in regards to the share market is “a measure of uncertainty about the future returns provided by a stock”. The more uncertain the returns of a stock, the higher the risk and the more volatile the share price will be as the market attempts to assign a ‘fair value’ to the share price.

Volatility is expressed as a percentage and usually ranges between 10-60% for most single stocks. There are two basic types of volatility referred to in the warrant market, the first is called “Historic Volatility” which is simply a measure of the actual volatility experienced by an underlying share price over time. Historic volatility looks backwards at a past period. The other term which is most commonly used in warrants markets called “Implied Volatility” is the volatility that is derived from the warrant pricing model, this will be explained below.

To understand Implied volatility we will start with the basics of warrant pricing. A warrant is priced using a mathematical formula called an option (warrant) pricing model. This formula takes six factors into account to calculate the warrant price:

1) stock price,
2) exercise price
3) expiry date
4) interest rates
5) dividends and
6) volatility

At any one time the first 5 of these factors can normally be easily identified, the unknown factor is “ volatility”. It is therefore possible to enter the desired volatility level into the formula to obtain your so-called “fair value”. However what really happens in practice is the reverse. As the first 5 factors are known, when the warrant price is set in the market you simply solve the formula to extract the implied volatility. That is, the level of volatility that is ‘implied’ by the current market price of the warrant. Implied volatilities will almost always be higher than historic volatilities.

Lets take a simple example of when a warrant issuer lists a new warrant. Upon listing the warrant the issuer will look at the historic volatility of the underlying share price and also at the implied volatilities of any other listed warrants over the same stock. The issuer will then determine what they believe to be a fair implied volatility level to sell the warrant and will begin making a bid and offer price based on this. If there is very strong demand for the warrant and the market price of the warrant is forced up, though the share price and other factors have not changed, it will result in an increase in implied volatility. The same can happen in reverse, where strong selling pressure can result in a fall in implied volatility.

Implied volatilities are a good measure of the market’s views about the future movements or volatility for a particular stock (or even for the market as a whole). If market forces push up the price of a particular warrant even though the stock price is not changing (increasing the implied volatility) it may be that the market is expecting increased movements from the stock in the future, the reverse can also be true for a falling warrant price. Therefore, when warrant prices move independently of the mother share this may be the cause of the market (buyers and sellers) changing their view on the value for the warrant and therefore changing it’s implied volatility.

So, Implied volatilities are important for warrant investors because they can effect the price of the warrant even though the share price may not change. Implied volatilities are constantly changing and may move several times a day for an active warrant. Implied volatility will also tell you about the relative price of warrants over the same counter. Generally speaking, all warrants over a particular counter usually trade at similar implied volatilities, say within a 10% range. If a warrant trades at the implied volatility deviated significantly from other warrants over the same underlying stock it may mean that the warrant is more expensive or cheaper than the other warrants over the same stock.

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