Option pricing is affected by a number of well known variables. Once you have an option position in place, whether it includes calls or puts, that you bought or sold, there are only a few things that can affect the price.
1. Stock Price
This relationship is the simplest concept to understand. The fact that stock price impacts option pricing is obvious and the first concept that is usually understood by people new to options. Calls go up when the stock goes up. Puts go up when the stock goes down. If we are bullish we can buy calls or sell puts. If we are bearish we 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 we can build an almost infinite number of trades to take advantage of any imaginable trend. This is the power of options.
2. Time Remaining In the Option
It’s intuitively obvious that if you want to have control of 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|
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. Personally, when I consider protective puts, I am looking 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. That 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. And just like the time seems on your vacation, the value decays faster and fast as the end approaches.
3. Implied Volatility
For traders new to options, implied volatility is the most difficult factor to understand. There is no corollary 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 imagine implied volatility as the flame in 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 the case of RIMM and its upcoming earnings. We are seeing a rise in options pricing that is not related to anything other than the anticipation that stock will move after earnings. This is a well-known and documented phenomena in stocks like RIMM. AAPL, ISRG, GOOG, and SNDK are also known for this. These stocks can make huge movements after an earnings event. This “risk” is what drives up the implied volatility and options pricing up and down. That behavior presents opportunities for options traders.
4. Risk Free Interest and Dividends
There are two other factors which affect options pricing: risk free interest rate and dividends. These are 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 do not see these changes very often.
I am writing this article because 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 “Sometime 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.
The truth is that these three things are essential concepts to understand when it comes to trading options. Once you have your options trade in place, these are the most important factors impacting the value of your trade:
- Stock Price
- Time Decay
- Implied Volatility
How important are these? I would put them on the same level of importance as:
- Gas Pedal
- Steering Wheel
You could never drive a car without understanding these three things. It 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).
Luckily, you have found OptionsANIMAL. This is the perfect place to learn about and master these concepts.