Accredited Investing Education

Learn About Option Pricing

By Greg Jensen
OptionsANIMAL CEO and Founder

The Greece situation is resolved right?  The market is headed higher right?

The VIX says the market is bullish, then another shoe drops and the market drops along with it.  Trading this market can be difficult in the good times and impossible in hard times.  The key to successfully trading this market is to have a sound understanding of options. Once you have an option position in place, whether it includes calls or puts, there are a few mains things that affect options pricing; stock price, time remaining in the option, implied volatility, risk free interest and dividends. These factors can seem very complicated at first. This is especially true when you look at the relationship between options pricing and the Black-Scholles model.  However, if you look at these factors from a simple perspective, it can help you understand the basis behind the option instruments, which in turn will help you be a better trader.
Stock Price

This relationship is the simplest concept to understand. The fact that stock price impacts option pricing is obvious and is usually the first concept understood by people new to options. Calls go up when the stock goes up. Puts go up when the stock goes down. If the stock is trending bullish you can buy calls or sell puts. If the stock is trending bearish, you can buy puts or sell calls.

Important advice: you generally do not want to sell options without having another option or stock to cover it. This is called naked selling. As the saying goes “You can lose more than your dignity going naked.”  Using a combination of stock, calls, and puts you can build an almost infinite number of trades to take advantage of any imaginable trend. This is the power of options.
Time Remaining In the Option

It’s intuitively obvious that if you want to control something for a longer period of time, it will cost more money. Just like that beach house down by the shore. Nightly rentals are going to be pretty expensive, let’s say $750 per night. However, if you want to rent for a week, it’s going to cost $4,550. And if you want to lease for the summer, it’s going to cost you $40,500. If you are one of those people who love the beach year round, you can opt for the one-year lease at $73,000 for the year. On the face, those number look pretty expensive. But, let’s break it down.

Term Total Cost Cost Per Day
1 day $750 $750
1 week $4,550 $650
1 season $40,500 $450
1 year $73,000 $200

We can see that clearly the best deal is the one year option. This is similar to the concept of time value in options. Longer term options cost more over all, but they are cheaper.

This is one of the reasons why at OptionsANIMAL, we recommend that you use protective options with a longer term. When I consider protective puts, I look at a minimum of 90 days. This gives me protection I need and the time to adjust my trade after the event passes. By the way, if you are trading RIMM, earnings is on June 24. RIMM is one of those stocks that gaps on earnings. Do you have your protection?

As the remaining value of your beach house lease becomes worth less and less over time, so does that value of the options. The value decays faster and faster as the end approaches.

 

Implied Volatility

For traders new to options, implied volatility is the most difficult factor to understand. There is no correlation to it with traditional equities like stocks or ETFs. However, it’s really a straightforward concept. Simply stated, implied volatility is a measure of the future risk.

I like to imagine implied volatility as the flame in a hot air balloon. The bigger the flame the higher the balloon rises. Implied volatility increases and causes the options pricing to rise. When it cools off the balloon will fall. This is exactly what happens with options. Take for example, RIMM and its upcoming earnings event. We are currently seeing a rise in RIMM’s options pricing that is not related to anything other than the anticipation the stock will move after earnings. This is a well-known and documented phenomenon in stocks like RIMM, AAPL, ISRG, GOOG, and SNDK. These stocks tend to make huge movements after an earnings event. Risk is what drives up the implied volatility and options pricing up and down. This kind of behavior presents opportunities for option traders to make money.

I often run into people who do not understand the concept of implied volatility. One time, I had a student have the light-go-on. He had the “aha! moment” and proceeded to tell me that, “Sometimes you run into things in your life and you say to yourself ‘I don’t understand that.’ and somehow you convince yourself that it’s not something that you really need to know and then you just move on. That is the way that I used to think about implied volatility.” That might be true for things like astrophysics or philosophy, but it’s not true for trading options.

 

Risk Free Interest and Dividends

There are two other factors that affect options pricing: risk free interest rate and dividends. These should not ignored when we trade options. Generally, these factors do not change dramatically, therefore, we tend to neglect them. But keep in mind, if a stock changes its dividend (e.g., BP?) or the interest rate changes (e.g., the FOMC ends its “For the Foreseeable Future” policy) you will see options pricing changes. We just don’t see these changes very often.

 

Essential Concepts

There are three essential concepts to understand when it comes to trading options. Once you have your options trade in place, these three things are the most important factors impacting the value of your trade:

  1. Stock Price
  2. Time Decay
  3. Implied Volatility

How important are these? I would put them on the same level of importance as:

  1. Gas Pedal
  2. Steering Wheel
  3. Brakes

You could never drive a car without understanding these three things. It’s obvious that you wouldn’t even try. Yet, I run into people who have mastered the concepts of stock movement (Delta) and time decay (Theta) and have essentially no understanding of Implied Volatility (Vega).  If you want to improve your results in these times of uncertainty, options can truly help you attain that goal.

Read more: http://community.nasdaq.com/News/2012-02/learn-about-option-pricing.aspx?storyid=120987#ixzz1nhhnhDwp