Trading in the stock market is exciting. Through careful research, you make predictions about the future of a company, then you bet on them through your trades. If you buy shares that increase in value, you can make a profit.
Of course, investing in stocks can be costly you need enough cash to cover your transaction. More importantly, there is a substantial amount of risk involved. Unexpected events within the market, the industry, or the individual company can suddenly reduce stock value, leaving you with shares worth far less than the prices you paid.
Trading options is an attractive alternative to buying and selling shares outright. Your options contract gives you the right to buy or sell stock at a pre-determined price the strike price until the contract expires.
A contract to buy stock is referred to as a call option, and a contract to sell stock is referred to as a put option.
The most you can lose is the premium you pay for the options and that’s only if you choose not to sell or exercise your options, allowing them to expire instead.
Understanding how the premium is calculated is key to making smart decisions about options trading.
Two primary factors affect the premium you pay for options.
First, there is the intrinsic value of the contract. That figure is calculated by measuring the current price of the underlying stock against the option’s strike price.
For example, if you have a call option to buy ABC at $45 per share, and it is currently trading at $50 per share, your option is “in the money”. The intrinsic value of your contract is $5 per share.
If you have a put option to sell ABC at $45 per share, and it is currently trading at $42 per share, your option has an intrinsic value of $3 per share.
The second element that contributes to premium pricing is less straightforward. It is the time value of the options contract.
This is an extra amount that investors are willing to pay based on their expectations about how the stock value will change before the options expire.
Typically, the more time remaining before the contract’s expiration date and the more volatile the underlying stock is, the more you will pay in options premiums.
Consider some of the most volatile stocks on the S&P 500 versus the least volatile over the past three years:
Implied Volatility (IV) is a calculation of how much an option’s underlying stock price will change before the contract’s expiration date.
While the figure is based on historical information, like price changes over time, recent price changes, and available information on the future of the industry and the company, IV is not a guarantee. It is a prediction. The future of the underlying stock price could be higher or lower than the IV used to calculate options premiums.
Stocks with low IV aren’t expected to fluctuate dramatically before the options expire. Conversely, stocks with high IV are expected to increase or decrease in value sometimes both during the period covered by the options contract.
You can learn what investors and analysts expect from a particular stock by examining the IV, which is written as a percentage. For example, if a stock has an IV of 10%, the market has predicted that a year from now, the stock will be priced within 10% of today’s value.
Calculating the Implied Volatility of an option can be complicated.
Fortunately, there are tools available online to assist. If you prefer to find the IV yourself, you will need five pieces of information:
These figures can be entered into a mathematical equation called the Black-Scholes model to determine an option’s IV.
As you become more familiar with options pricing, you are sure to notice that the Implied Volatility of a particular stock is not necessarily the same between options contracts.
This makes sense when the options have different expiration dates, but it doesn’t quite seem logical when the options have identical terms except their strike prices are different.
Mathematical models for calculating IV show that the strike price shouldn’t affect Implied Volatility. There should be a direct unit for unit increase in IV as expiration dates lengthen. On a graph, this would be a straight line.
In reality, IV doesn’t follow the expected pattern. Options with strike prices at the money form the base line, and the upwards curve on either side reflects strike prices that are more out of the money and more in the money respectively.
The reasoning for this pricing phenomenon has more to do with economics and human nature than mathematical equations.
Speculators may purchase out of the money options as a high-risk, high-reward strategy to capitalize on sudden market declines.
Though chances are slim that they will get the timing just right, they could be in for a massive payout if they have the right options at the right time.
Investors may also purchase options at different strike prices in an effort to mitigate the risk inherent in other investments.
If you own stock and want to earn passive income, covered calls are a popular way to generate income.
The strategy involves selling call options against your shareholding. For example, if you own 100 shares of Facebook, Netflix or Alphabet, you would sell 1 call contact to create a covered call position.
In the run up to earnings, the expectation for underlying stock prices to rise or fall more than normal is high, and so implied volatility rises, resulting in higher call option prices.
If you have a plan to hold your stock for the long-term, you could view this hike in option premium as an opportunity to create some passive income short-term.
Sometimes, the call option premium can be as much as 5% or more of the entire value of the stock price!
Regardless of whether you are buying put options out-of-the-money to capitalize on expected share price declines or selling covered calls to profit from a current spike in implied volatility, you’ll want to select a good options broker who understands the risks and rewards of trading implied volatility.
Not all brokers are made equal when it comes to options trading and profiting from implied volatility swings in particular. For example, you can trade options on Robinhood, but its options trading tools are basic.
In contrast, the TD Ameritrade thinkorswim platform is the gold standard when it comes to stock and options trading.
If you are considering ways to trade implied volatility, thinkorswim provides risk graphs to help you visualize the upside and downside of your options strategy, and how they varies over time.
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