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Ancient Babylonian philosophers considered all things to be constituted of one or more of the four classical elements: earth, air, water, and fire. In this world view, the natural environment consisted of objects composed of varying portions of each of these fundamental elements or forces. While modern atomic theory has supplanted this concept, these historic constructs can help us understand the importance of primal forces impacting various option trades.
Similar to the early Babylonians' views, the options world is ruled by three primal forces: price of the underlying, time to options expiration, and implied volatility (IV). Trades are most profitably constructed when the trader considers the impact each of these three forces could have on the options trade in question.
For the new options trader, the impact of these three fundamental forces may be confusing. What's more, the magnitude of influence of each of these forces on a trade's profitability is easily underappreciated. Failure to consider each of these forces and its individual effect will reduce the probability of a successful trade. Since most option traders come from the universe of stock traders where “only price pays”, investors are understandably reluctant at first to consider additional factors impacting a trade.
To better understand the initially confusing manner in which options respond to their milieu, it is helpful to dissect an option’s price into its two components: extrinsic value and intrinsic value. Remember that the quoted price of an option reflects the sum of the intrinsic (if any) and extrinsic values. Intrinsic value of an option is that portion of the premium which is in-the-money and is impacted solely by the price of the underlying. Extrinsic value is also known as time premium (or, less generously, “sizzle” as opposed to “steak” of the intrinsic value) and is impacted by both time to expiration and IV.
We'll continue this discussion in a future post this week. Stay tuned!
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
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Dan Passarelli maintains a cross-marketing relationship with TradeKing.