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In part 1, I introduced the 3 primal forces of the options world: price of the underlying, time to options expiration, and implied volatility (IV). Like the classical four elements of nature - earth, water, air and fire - most if not all options action stems from the interaction of these 3 drivers.
Perhaps the most easily understood of the options price influences is the price of the underlying. All stock traders are conversant with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of underlying stock prices are well beyond the scope of this discussion, but suffice it to say it is one of the three pricing factors and probably the most familiar to traders.
Time to options expiration is also easily understood, in part because it is the only one of the forces that moves unidirectionally. The reason time impacts option positions significantly stems from the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy you choose, the passage of time can impact the trade either negatively or positively. Either way, though, time passing always "tells" in an option's changing value.
The third price influence is perhaps the most important. It is without question the most neglected and overlooked component: implied volatility. Implied volatility, taken together with time, defines any option's extrinsic value. The value of implied volatility is inversely related to price of the underlying. That is, IV represents the marketplace's aggregate view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can wax and wane as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).
New options traders should direct their attention to understanding each of these options pricing influences. The options markets are ruthlessly unforgiving to anyone who ignores the impact of the valuation metrics that underpin daily life in this world.
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.