Hi Shoppers,

A quick lesson on an important topic today ..

Factors of an Option Price

 

Of all the factors that make up the price of an option, there is only one that is an unknown:  volatility.

 

The known factors in an option price are:

 

• Stock price
• Strike price
• Days to expiration
• Interest rates
• Dividends

 

What is volatility? The simplest definition is the measure of the movement of a security.

 

A security that has large price swings is going to have a higher volatility than a security that moves more slowly.

 

There are two types of volatility that we look at when we are pricing options …

 

The first is realized – or historical – volatility, which measures in a timeframe (10 day, 20 day, etc) of the underlying security’s movement.

 

It is a measurement of what has already happened.

 

The other is implied volatility, which is the volatility that is priced into the listed options of that security.

 

The options listed on a high-flying stock that is very volatile, are going to have more dollar premium (they will cost more), creating a higher implied volatility.

 

A stock that is more sedentary and doesn’t move around so much, will have lower-priced options. The odds of those options going into the money is less likely than a more volatile stock, thus there is no reason to pay up for them.

 

Generally speaking, implied volatility is taking its cue from the historical volatility.

 

So a good rule of thumb is to purchase options that are trading at a lower implied volatility than the historical volatility.

 

And the opposite is also true – sell the higher implied volatility options.

 

Sounds pretty simple …

 

But our Option Pit 4th of July specials will make it even easier. Check them out!

 

Thanks for Reading … See You Next Tuesday.

Licia Leslie