3 Things All Option Traders Must Know

03/30/2011 5:00 am EST

Focus: STOCKS

Elizabeth Harrow

Financial Analyst, Schaeffer's Investment Research, Inc.

An option trader’s livelihood depends on being able to identify important pricing factors. Here are three crucial catalysts that must be analyzed with each and every trade.

As you may well know, it's very common for option players to close out their trades without ever touching the underlying equities.

In other words, they're not looking to acquire or sell the underlying stock; these speculators simply want to capitalize on changes in the option's price (known as "trading for premium"). Obviously, then, every derivatives trader worth his or her salt must be well-versed in the factors that influence an option's price.

Equally as obvious, one of the main factors that affect an option's price is the price of the equity on which it is based. (Assuming all other things are equal, a call option's value will increase in direct relation with the underlying, while a put option's value will increase in inverse relation with the underlying.)

But how much do you know about the other catalysts that can prompt major changes in the price of a call or put contract? And do you know which Greek measures your option's probability of finishing in the money? Read on to learn more.

1) Implied Volatility

The first and most nebulous factor is known as implied volatility, or “implieds,” for short. In the simplest terms, implied volatility is a measure of the market's expectations for the underlying equity's performance during the life span of the option.

When implied volatility is high, options will be more expensive to purchase. Conversely, low implied volatility will translate to more affordable option prices.

Generally speaking, heightened implied volatility correlates with bearish sentiment, while low implied volatility suggests a bullish mood.

Additionally, an option's implied volatility will rise ahead of scheduled events, such as earnings reports and new product launches. These occurrences can often spark major movements in the price of the underlying, and the expectation of such a move results in higher implieds. Once the anticipated event occurs, implied volatility will immediately drop.

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, you need a much bigger move out of the underlying stock to profit from the trade. That's because you're paying a higher premium to buy the option in the first place.

For this reason, be wary of buying calls or puts directly prior to an earnings report or other scheduled event. When implied volatility is over-inflated, your option could potentially drop in value, even if the stock moves in the direction you anticipated.

On the other hand, hefty implied volatility readings can be a boon for the option writer. If you sell a call option with very high implieds, that translates to a higher premium payment in your pocket. Then, when implied volatility drops back to its usual levels, you can buy to close your option at a discount.

So, how do you judge whether implieds are high or low?

By comparing the option's current implied volatility against the stock's historical volatility, you can determine whether the contracts are relatively cheap or comparatively pricey. Just make sure that you match up the option's life span with the proper time frame.

For example, if you're trying to gauge implied volatility on a May-dated option, compare that number against the equity's two-month historical volatility. If the implieds are higher than historical volatility, the options are more expensive than usual. If the historical figure is higher, the options are trading at a bargain.

(Schaeffer’s has a tool for doing this comparison here.)

NEXT: Option "Greeks" Theta and Delta

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2) Time Value and Time Decay

Another factor that affects the price of your option is time value. This is the reason that a January 2012 call will be more expensive than its July 2011 counterpart, because you're buying more time for the underlying stock to move as you expected. In-the-money options carry both intrinsic value and time value, while out-of-the-money options consist solely of time value.

Time value can be tricky, because it doesn't erode at a consistent pace. The loss of time value on your option is referred to as time decay, and it accelerates as the option draws closer to its expiration date. The rate at which your option will lose time value can be measured by Theta, which is one of the infamous option "Greeks."

Much like implied volatility, time decay works against the option buyer. For every day that passes, your out-of-the-money option will lose time value, thereby decreasing the contract's worth.

For the same reason, time decay works in favor of the option seller. Should you need to buy to close your sold option, the erosion of time value should translate to a lower purchase price (all other things being equal).

3) Delta

To clear up a common misconception, Delta does not affect an option's price.

Instead, Delta is yet another one of those metrics known collectively as the Greeks. Its function is to measure how much your option's price will change for every one-point gain in the underlying stock.

Call option Deltas will always be a positive number between 0 and 1, while put option deltas will always be a negative number between 0 and -1, since a put option will lose value as the underlying stock rises.

For example, if your option has a delta of 0.7, it means that your call option will gain 70 cents for each dollar the stock rises. 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. This indicates that the options are now moving point-for-point with the underlying security, whether directly (for the call) or inversely (for the put).

For this reason, an option's delta is thought to roughly correspond with the contract's chances of finishing in the money. So, that call option with a Delta of 0.7 would be said to have a 70% chance of expiring in the money. (Keep in mind that this is an estimation, not a guarantee.)

A higher Delta usually suggests that greater benefits can be derived by purchasing the option, rather than selling it. That's because a closer correlation with the underlying equity maximizes the benefits of leverage for the option buyer. Accordingly, options with lower Deltas may be better suited for option writers.

You'll also sometimes hear Delta referred to as the "hedge ratio," because some traders utilize an option's Delta to determine how they should hedge their investments.

For example, let's say that you purchase one call option controlling 100 shares of XYZ with a Delta of 0.5. Assuming that this option has a 50% chance of finishing in the money, you decide to hedge your long position by shorting the underlying stock. Using the Delta as a hedge ratio, you would want to sell short 50 shares of XYZ, or 50% of your total exposure.

By Elizabeth Harrow, contributor, Schaeffer’s Trading Floor Blog

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