Understanding How The Options Market Moves
Many traders have entered options trades only to see their options change in value with little to no change in the underlying stock.
This can be very confusing if you don’t understand the different variables that factor into an option’s price.
Only one of these variables has to do with the price of the stock.
I break them down for you below so you can see how option prices are influenced and what you need to know to use them successfully.
Options Price Input #1: The Price of the Stock
A lot of traders only think of this variable when they are trading options.
The price of the underlying stock determines what the intrinsic value of the option is. When the price of a stock moves higher (with all other things held equal), call values will increase and put values will decrease.
When the price of a stock moves lower, call values will decrease and put values will increase.
This is probably the easiest factor to understand, but many traders put too much emphasis on this one factor.
Remember, there are five more variables…
Options Price Input #2: Strike Price
The strike price is another component in the intrinsic value of the option.
Intrinsic value is the difference between the strike price and the stock price. If the option is out of the money, it will have no intrinsic value.
This is the only variable that is static after the trade is entered.
Once you buy an option at a specific strike price, that strike price will never change.
Options Price Input #3: Time Until Expiration
Time until expiration determines how much time value is in the option.
Thinking about this logically, for any option, the longer there is until it expires, the higher the chance it will end up being worth something.
This is why, as time moves forward, the value of an option decreases. There is less time for the option to end up in the money, so the value of the option moves lower.
This is most noticeable in the last two weeks of an option’s life cycle, and is one of the things that catches traders most off guard.
Always be aware of time decay.
Options Price Input #4: Implied Volatility
The expected volatility in the underlying stock is a major factor in the price of its options.
The more a stock is expected to move, the higher the likelihood the option ends up in the money.
With all other factors held equal, an increase in expected movement will increase both call and put values.
This means that changes in expectations can have large effects on the value of your options position.
Options Price Input #5: Interest Rates
The final two factors have a small, but still relevant effect on the price of an option.
The reason interest rates affect options prices is rather complicated, but you should know the way that changes in rates can change options values.
With all other factors held equal, a rise in rates will increase the value of calls and decrease the value of puts.
Conversely, a decline in rates will decrease the value of calls and increase the value of puts.
Options Price Input #6: Dividends
Again, dividends have a small effect on options prices but one worth noting.
The way this works is complicated, but you should know how it affects options prices. If dividends rise, call values will decrease and put values will increase.
If dividends fall, call prices will increase and put values will decrease.
Its difficult to account for this while trading options, and generally, you should not be too concerned about it.
Just be aware of this dynamic.
Options Shouldn’t Scare You
This all sound very complicated.
While there are six factors that go into an options price, there are definitely some that carry more weight. Typically, you should focus on intrinsic value, time to expiry and implied volatility.
Options require a bit of thought and practice, but they make you a versatile trader, so don’t let that stop you from trading like an AlphaShark!!
AKA, “The Alpha Shark”