This is perhaps the most common question I hear as an options educator. Why isn’t it an easy process to make a selection? The simple answer is, “because they are complex investing instruments.” During my basic options education between 2005 and 2009 I gained a mountain of respect for the options instruments. Learning and understanding their behaviors and the components involved in determining their values is an important step in the overall educational process.
The components that determine the value of options are these:
- Equity Price
- Strike Price
- Time to expiration
- Implied Volatility
- Dividend (if any)
- Risk Free Interest Rates
Of these components, the biggest ‘wild card’ is the implied volatility. The concept of volatility is worth studying by itself! But, that’s not ALL that must be considered in selecting the strike price. All options’ values can be subdivided into Intrinsic Value and Extrinsic Value. And, just to keep an options trader on their toes, the listed components only affect the extrinsic value of options!
Serious options investors demonstrate the ability to study in multiple views. First, take out the binoculars and learn the details of the structures, behaviors, rights and obligations of the instruments. Then, put them down for a landscape view to see how the structures fit into your overall investing strategy. By transitioning smoothly between details and big-picture (and applying your developing understanding in a safe environment) you will be able to trade these vehicles successfully.