This article is part of the series

The 3 Primal Forces in Options Trading: Part 2

Options Trading TradeKing

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Dan Passarelli continues his exploration of the 3 major drivers of options prices

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.



Regards,

MarketTaker Mentoring TradeKing All-Star Commentator

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While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point, there is no guarantee that this forecast will be correct.

TradeKing selects and defines as All-Stars certain independent market commentators who are recognized industry personalities and experienced traders and who provide timely market commentary via the TradeKing All-Star blog at  http://community.tradeking.com/members/tk-all-star/blogs. Each All-Star commentator’s bio, related qualifications and disclosure as to their relationship with TradeKing can be found on the All-Star blog roster, available at  http://community.tradeking.com/members/tk-all-star/details. The selection of All-Stars commentators is solely based on the quality and style of the content provided. TradeKing does not measure, endorse, or monitor the performance or correctness of any statement or recommendation made by independent All-Stars commentators on TradeKing.com. Supporting documentation for any claims made in this post will be supplied upon request by the author of the post, Dan Passarelli, who is solely responsible for the views expressed here. Send a private message to All-Stars using the link below the profile image.

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs. 

Dan Passarelli maintains a cross-marketing relationship with TradeKing.

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