How Deep Is Deep-In-the-Money?
Suppose stock A has an annualized volatility of 40% and stock B has an annualized volatility of 20%, and both are selling for $100.
These volatilities tell you that A can be expected to fluctuate by about 40% of $100, or $40, in a year’s time; and that in that same time B can be expected to fluctuate by about 20% of $100, or $20. Of course either one can fluctuate more or less; the volatility merely tells you what is typical.
So after a period of one year, you can expect A to be about 40% higher, or $140, or about 40% lower, which is $60; and for stock B, $120 (=$100 + $20) and $80 (=$100 – $20) are the kinds of prices that would not surprise you.
Another consequence of these volatilities is the following: Stock A will rise to $140 in one year just as easily as stock B will rise to $120 in the same time; and stock A will fall to $60 just as easily as stock B will fall to $80. The volatility (assuming it is well estimated) gives you a sort of benchmark for the kinds of prices you can expect to see in the future.
The volatility is actually what statisticians call a “standard deviation,” which is used frequently as a yardstick. For instance, two standard deviations from the average is about the same distance from the average in terms of its probability of occurrence, whatever the average and standard deviation might be. (Once again, I am speaking loosely in order to develop your intuition –for those more technically inclined, the distributions are of course critical to this conclusion).
Suppose a one-year call option on stock A has a strike price of $80 and a one-year call option on stock B has a strike price of $90. Both options are in-the-money (ITM). But which one is more ITM? Another way to ask this question is: How far are these strikes from each stock’s current price of $100 in terms of the respective annual standard deviations?
$80 is $20 below $100, which is half of $40, one standard deviation for stock A; and $90 is $10 below $100, which is likewise half of $40, one standard deviation for stock B. So each option’s strike price is half of one standard deviation below its respective stock’s current price. Thus stock A will be just as likely to close above its call option strike price of $80 as B will be to close above its call option strike price of $90. The two options are equally ITM.
Using the standard deviation (the volatility times the current stock price) as a benchmark and measuring strike prices in this way, you can develop a more uniform approach to choosing strike prices, such as for covered writes.