These Concepts Are Essential for Any Options Trader
Fred Oltarsh at Options Strategy Network explains that by understanding liquidity, implied and historical volatility, and the skew, options traders are able to build strategies to either mitigate risk or speculate in a manner that provides a reasonable opportunity for successful trading.
The first topic to understand is liquidity. The importance of liquidity is often overlooked in options trading. Whether one is trading standard or binary options, it must be clear to the trader how expensive it is to initiate and liquidate a position. The wider the bid/ask spread as a percentage of the contract value, the costlier it is to trade the particular contract. Ideally, a trader would benefit from the largest contract with the bid/ask spread at a minimum. For those who don't focus on commissions and slippage, options traders don't have a chance of making money in the long run.
It is always important to evaluate the implied volatility of the option one is trading in comparison to the historical volatility of the underlying. One might use the 20-day historical volatility-or a lengthier period-to determine how the implied volatility of the options compares. Frequently, traders will sell options thinking that there is a small degree of risk in the transaction, but at the same time they will sell options with an implied volatility at a level that is less than the historical volatility of the underlying. In stocks and stock index futures, due to the structure of the implied volatility skew, selling calls can be a particularly poor value. Frequently, people participate in the covered call, a transaction which writes calls against a stock they have purchased. While this is the same as selling a synthetic put, the strategy is often executed without regard to the comparison between the historical volatility of the underlying and the implied volatility of the option they sell.
While the paragraph above briefly discusses the relationship between historical and implied volatility, understanding those concepts is essential for any options trader. Once that relationship is understood, one can evaluate the implied volatility skew of the options series they are trading. The skew is created by the supply and demand of options depending on the structure of the underlying market. In the E-mini S&P and most other stocks, the demand for puts and the willingness to sell calls provides for a substantial put skew. The implied volatility of out of the money puts is much greater than the implied volatility of out of the money calls. Each futures contract has a slightly different skew, and as such, provides different opportunities to create options trading strategies which will meet their risk/reward requirements. To read the entire article click here.
By Fred Oltarsh, Proprietary Trader and Editor, Options Strategy Network