In the world of options trading, it is very common for traders to exit their positions without ever buying or selling the underlying shares. Traders may not have designs on the stock itself; they simply want to capitalize on changes in the option's price. Therefore, in order for a derivatives trader to be successful, he must be well-versed in all factors that influence an option's price.
One of the obvious factors impacting an option's value is the price of the underlying equity. (Assuming all other things are equal, a call's price will increase in direct relation with the underlying stock, while a put option's value increases in inverse relation with the underlying.) There are additional catalysts, however, that can prompt major changes in the price of a call or put contract.
The first and most nebulous factor is implied volatility, or IV. In the simplest terms, implied volatility measures market expectations for the underlying's price movement within the life span of the option. When implied volatility is high, option premiums will also be elevated. Conversely, low implied volatility means options will be priced lower.
Typically, an option's implied volatility will rise ahead of scheduled events, such as earnings reports or significant product announcements (such as FDA decisions). These events can often result in major swings in a stock's price, and the expectations for such a move will mean higher implied volatility readings. Once the anticipated event occurs, implied volatility tends to drop immediately.
What does this mean for option players? Well, that depends on whether you're buying or selling. If you purchase an option with high implied volatility, the stock needs to move more dramatically in order to yield a profit, as the premium was higher in the first place.
For this reason, traders need to use caution when buying calls or puts immediately before an earnings report or other scheduled event. When IV is notably inflated, the option could potentially drop in value after the event's conclusion, even if the stock moves in the expected direction.
Contrarily, higher-than-usual IV measures are often considered a boon for the option seller. If you sell an option with high implieds, you are collecting a larger credit at the outset of the trade. If IV then reverts to "normal" levels, the option can be bought to close at a discount, allowing you to keep the difference as profit.
You can use animplied volatility montage to help you judge whether or not implieds are elevated or not. By comparing the option's current implied volatility against the stock's historical (or actual) volatility, you can see whether the contracts are relatively cheap or comparatively expensive.
It's important to gauge the option's life span against the proper time frame. If you're trying to analyze implied volatility on a front-month option, compare that number against the equity's 30-day historical volatility. If the IV reading is higher than historical volatility, the options are more expensive than usual. If the historical figure is higher, on the other hand, you could theoretically buy options at a bargain.
Time value and time decay
A second factor impacting an option's price is time value. This is the reason a call with six months until expiration will be more expensive than a shorter-term option at the same strike price. There is more time in the life span of the option for the underlying stock to move as expected. In-the-money options contain both intrinsic value and time value, while out-of-the-money options consist of time value alone.
Time value can be tricky, because it erodes at a non-linear pace and is therefore hard to predict. The loss of time value in an option is called time decay, and accelerates as expiration nears. The rate at which an option will lose time value can be measured by theta, one of the "Greeks," which are measures that track an option's price sensitivity to various factors.
Much like implied volatility, time decay works against the option buyer. Each passing day, an out-of-the-money option loses time value, thereby dropping in price. For the same reason, option sellers can benefit from time decay -- when the sold option is bought to close, any time-value erosion should translate to a lower purchase price (assuming all other factors are equal).
Delta is another one of the Greeks used to measure a variable's potential impact on an option's price. Delta expresses the degree by which an option's value will change for every one-dollar shift in the underlying. Call option deltas are positive numbers (between 0 and 1) and put option deltas are negative. This is because a put option will typically lose value as the underlying equity moves higher.
For example, if your call option has a delta of 0.5, it equates to a move higher of 50 cents for every $1 advance in the stock. As in-the-money calls get close to expiration, they will approach a delta of 1. As an in-the-money put approaches expiration, its delta will move closer to -1. At a reading of 1 or -1, options will effectively move point-for-point with the underlying security, whether directly (for the call) or inversely (for the put).
An option's delta is therefore thought to roughly correspond to the contract's percentage odds of finishing in the money -- so, a call option with a delta of 0.5 would have a 50% chance of expiring in the money. (Keep in mind that this is an estimate, not a fact.)
A closer correlation to the stock itself will maximize the benefits of leverage for the option buyer. As such, options with higher deltas are usually better suited for option buyers, while those with lower deltas may be a better choice for those looking to sell option premium.
You may sometimes hear delta referred to as the "hedge ratio," because some traders will use an option's delta to determine how they should hedge their investments. For example, let's say you purchase one call option -- controlling 100 shares of XYZ -- and the option's delta is 0.50 (so has a 50% chance of expiring in the money at the time of purchase). You might choose to hedge this long position by shorting the underlying stock. Using the delta as your hedge ratio, you would want to sell short 50 XYZ shares.
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