There are seven factors or variables that determine the price of an option:. Of these seven variables, six have known values, and there is no ambiguity about their input values into an option pricing model.
But the seventh variable—volatility—is only an estimate, and for this reason, it is the most important factor in determining the price of an option.
Volatility can either be historical or implied; both are expressed on an annualized basis in percentage terms. Historical volatility is the actual volatility demonstrated by the underlying over a period of time, such as the past month or year. Implied volatility IV , on the other hand, is the level of volatility of the underlying that is implied by the current option price. Think of implied volatility as peering through a somewhat murky windshield, while historical volatility is like looking into the rearview mirror.
While the levels of historical and implied volatility for a specific stock or asset can be and often are very different, it makes intuitive sense that historical volatility can be an important determinant of implied volatility, just as the road traversed can give one an idea of what lies ahead. All else being equal, an elevated level of implied volatility will result in a higher option price, while a depressed level of implied volatility will result in a lower option price.
For example, volatility typically spikes around the time a company reports earnings. The most fundamental principle of investing is buying low and selling high, and trading options is no different. Buy Low and Sell High. Based on this discussion, here are five option strategies used by traders to trade volatility, ranked in order of increasing complexity. This strategy is a simple but expensive one, so traders who want to reduce the cost of their long put position can either buy a further out-of-the-money put, or can defray the cost of the long put position by adding a short put position at a lower price, a strategy known as a bear put spread.
For related reading, see: A Roaring Alternative to Short Selling. Note that writing or shorting a naked call is a risky strategy, because of the theoretically unlimited risk if the underlying stock or asset surges in price. In order to mitigate this risk, traders will often combine the short call position with a long call position at a higher price in a strategy known as a bear call spread.
In a straddle , the trader writes or sells a call and put at the same strike price in order to receive the premiums on both the short call and short put positions.
The rationale for this strategy is that the trader expects IV to abate significantly by option expiry, allowing most if not all of the premium received on the short put and short call positions to be retained. A Simple Approach to Market Neutral.
Writing a short put imparts on the trader the obligation to buy the underlying at the strike price even if it plunges to zero, while writing a short call has a theoretically unlimited risk as noted earlier. However, the trader has some margin of safety based on the level of premium received.
A short strangle is similar to a short straddle, the difference being that the strike price on the short put and short call positions are not the same. As a general rule, the call strike is above the put strike, and both are out-of-the-money and approximately equidistant from the current price of the underlying. In return for receiving a lower level of premium, the risk of this strategy is mitigated to some extent.
Ratio writing simply means writing more options than are purchased. The simplest strategy uses a 2: The rationale is to capitalize on a substantial fall in implied volatility before option expiration. A High-Volatility Options Strategy. In an iron condor strategy, the trader combines a bear call spread with a bull put spread of the same expiration, hoping to capitalize on a retreat in volatility that will result in the stock trading in a narrow range during the life of the options. The iron condor is constructed by selling an out-of-the-money OTM call and buying another call with a higher strike price, while selling an in-the-money ITM put and buying another put with a lower strike price.
Generally, the difference between the strike prices of the calls and puts is the same, and they are equidistant from the underlying. The iron condor has a relatively low payoff, but the tradeoff is that the potential loss is also very limited.
These five strategies are used by traders to capitalize on stocks or securities that exhibit high volatility. Since most of these strategies involve potentially unlimited losses or are quite complicated like the iron condor strategy , they should only be used by expert option traders who are well versed with the risks of option trading.
Beginners should stick to buying plain-vanilla calls or puts. Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews.
Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. There are seven factors or variables that determine the price of an option: Current price of the underlying Strike price Type of option Call or Put Time to expiration of the option Risk-free interest rate Dividends on the underlying Volatility Of these seven variables, six have known values, and there is no ambiguity about their input values into an option pricing model.
Two points should be noted with regard to volatility: Relative volatility is useful to avoid comparing apples to oranges in the options market. Relative volatility refers to the volatility of the stock at present compared to its volatility over a period of time.
On a relative basis, although stock B has the greater absolute volatility, it is apparent that A has had the bigger change in relative volatility. Short Straddles or Strangles In a straddle , the trader writes or sells a call and put at the same strike price in order to receive the premiums on both the short call and short put positions.
Ratio Writing Ratio writing simply means writing more options than are purchased. Iron Condors In an iron condor strategy, the trader combines a bear call spread with a bull put spread of the same expiration, hoping to capitalize on a retreat in volatility that will result in the stock trading in a narrow range during the life of the options.
The Bottom Line These five strategies are used by traders to capitalize on stocks or securities that exhibit high volatility. No thanks, I prefer not making money. Get Free Newsletters Newsletters.More...