Our robust, user-friendly reference for pricing options.
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By Philip Guziec, CFA | 08-13-07 | 06:00 AM | Email Article

As I've been developing the Morningstar approach to options, and trying to arrange and graph the options data in a way that makes an overwhelming stream of numbers intelligible, I stumbled into an issue--there really aren't any intuitive benchmarks for pricing options.

Philip Guziec, CFA, is a strategist on the alternative funds research team for Morningstar.

For example, if you are considering an option with an implied volatility (the common measure for the price of an option) of 28, is that expensive? Cheap? Average? It'd be nice to have a reference point to compare the implied volatility of an option with an index or industry value. Unfortunately, all the index volatility values aren't directly comparable, but more on that later.

I couldn't find a benchmark for the implied volatility of the options on a given stock--so we made one.

A Directly Comparable Index
The Morningstar Volatility Index (MVI) provides a reference point for the average price of options in the marketplace. You can search MVI values by industry and style box to find an anchor value to compare against the implied volatility of an option you're considering on any individual company.

For example, if you have a mid-cap growth specialty retail company, you can directly compare the MVI for mid-cap growth specialty retailers. That MVI value (let's say it's 32) is directly comparable to any option traded on a mid-cap growth specialty retail stock. Think of the MVI value for the industry the way you would a price/earnings (P/E) multiple. Like MVI, P/E is a crude measure, and there is much more to fundamental stock research than P/E, but if a company has a P/E far above the average for its industry, it is generally considered expensive, and if the P/E is far below that for the industry, it is considered cheap. So, in our example, if an option on a mid-cap growth company has an implied volatility much higher than 32, the option is probably expensive. If the option's price is much lower than 32, it is probably cheap. Our initial example of 28 is in the ballpark for the implied volatility of a mid-cap growth specialty retail company.

Here's How It Works
We can directly compare the individual option's implied volatility and the MVI value because of how the MVI is constructed. Technically, the MVI is an open-interest-weighted average of the implied volatility of the options on all stocks within the index.

I'll walk you through the details of that mathematical definition, but the key thing to remember is that the MVI is an index of volatility, while the other measures you commonly hear of are the volatility of an index. Let me repeat that: The MVI is an Index of Volatility vs. the Volatility of an Index. That means you can directly compare the volatility of the options on a stock that you're considering with the index of volatility value that most closely matches your company.

You can think of the open interest weighting of the MVI like market-cap weighting for stock indexes, except the market cap of the options market is measured by the open interest (the total level of investment by the market in a given option), and the price is measured by the volatility. To arrive at the MVI values, we calculate the implied volatility of all of the options in our universe, then multiply each value by the open interest. We add all of those values together and divide by the total open interest for all of the options in each style box, industry, sector, or other index that we're considering. All of the complexity and hard-core number crunching that goes into the construction of the index actually makes the index easy to use.

Because of the way the MVI is constructed (as an aggregate index of individual securities' volatilities), it has an edge on index volatility measures (which calculate the volatility of an index as a whole). You can't directly compare index volatilities with the implied volatilities of the options on a given stock because the index volatilities are skewed by the effects of diversification. A basket of stocks will be less volatile than each stock on its own, which is why investors buy a basket of stocks instead of putting all of their money in one stock. Diversification reduces risk at the same return level (in theory, anyway).

Thankfully, the robust MVI methodology can easily be applied to other indexes. So, not only are we calculating the MVI for all of the Morningstar Indexes (which I hope you'll look to first), we are also calculating the MVI for some key indexes that have index volatility values, such as the S&P 500. Like many option investors, I've kept an eye on the VIX (which measures the implied volatility of S&P 500 Index options) and other index volatility values for years, and I'd like to be able to calibrate my intuition between the MVI and the VIX, as well as other key volatility index values. So, I've posted both the VIX and the MVI for the S&P 500, on the Morningstar Options cover page right below the MVI style box. You'll also find MVI values for some other key volatility indexes as well.

I'm excited about the Morningstar Volatility Index, and I hope you'll find the concept as appealing and useful as I do.

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Philip Guziec, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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