Implied volatility vs stock Volatility

CFA Level II Derivatives
#1

In CAFI Exam 1 morning session Q 54 what is the difference between stock volatility and implied volatility, is not both are expectations of the volatility of the stock in the future?

Mazza concludes the discussion by stating, “The choice of an appropriate options strategy is dependent on two factors: your views of stock volatility, relative to implied volatility, and your expectations regarding market direction. For example, if you expect high stock volatility but are neutral on direction, a long straddle would be appropriate. However, if you only expect average stock volatility and are neutral on direction, a short put would be appropriate.”

Q. In Mazza’s concluding statement, he is least likely correct with regard to the:

  1. choice of the short put strategy.
  2. choice of the long straddle strategy.
  3. factors impacting the choice of options strategy.
    Solution

A is correct. If the expectation is for average stock volatility relative to implied volatility, and one is neutral on direction, a spread options strategy would be appropriate. The short put would be appropriate in the context of low realized volatility and a bullish outlook for stocks.

#2

short put is a bullish position, not a ‘neutral on direction’ … so that is all you need to know to answer the question here (least likely)…

with regards to your specific question, implied volatility is the markets future expectation of what the securities volatility will be.

#3

In this context, I think “stock volatility” refers to the actual volatility that will be realized on a stock.

When you purchase a call or put option, the price you pay depends a lot on the market’s forecast for volatility, known as “implied volatility.” If you are long a straddle, you want the actual volatility–“realized volatility”–to be higher than the implied volatility. Price fluctuations are good for an option holder–this is why the first part of the solution says that a straddle is appropriate if you expect “high stock volatility.”