The importance of the volatility effect in options trading is the focus of a new educational article by Professor Eric C. Chang, Chairman of Finance and Director of the Centre for Financial Innovation and Risk Management at the University of Hong Kongs School of Business, and Mr Kevin Cheng, Hong Kong Exchanges and Clearing Limited (HKEx) Derivatives Market's Vice President of Market Development, Training and Education.

The article is divided into three major sections. The first discusses the Black-Scholes option price formula, the second explains the differences between historical and implied volatility and the third examines the distribution of implied volatility for Hang Seng Index Options.

"Before starting to trade options, an investor should first understand that the value of an option is the function of five determinants: current underlying asset price, volatility, strike price, the risk-free rate of interest and the remaining life of the option," the authors explain in their conclusion.

"There is a general rule of thumb: buy options in low volatility and sell options during periods of high volatility," they add.

A copy of the article can also be found on the following website - www.hkex.com.hk - in the Library section, under the Reports of Derivatives Market. Past educational articles are also available on the website.