Options 101: Use Volatility to Your Advantage

Be aware of your trade's implied volatility

   

When I became interested in learning about options I didn’t know anything about volatility. Although options appealed to me as a new retiree for risk management of my investments, being a student at OptionsANIMAL opened many topics that have served me well as a conservative investor, including volatility. As the general market goes through the up-and-down cycle the value of options go through a cycle, too.

The value of options may be split into two main categories: intrinsic value (only found within in-the-money options) and extrinsic value (part of the value of in-the-money options AND out-of-the-money options.) The extrinsic value of options is based on a small list of criteria: stock price, strike price, time, risk-free interest rates, dividends (if there are any) and implied volatility (IV). In light of the Black-Scholes model, which tells us how to estimate the individual pieces of the options value, it’s clear that all separate characteristics except the IV value is easy to find. I view IV as the wild card of options where it can trump any other characteristic of options value.

One problem when you buy options, though, is the “threat of volatility crush.” Did you know that if you are a buyer of options when the IV is in a high range that you could suffer a capital loss in the option, even if the equity moves in the direction you expected? To fully understand risks and rewards that may come with any combination trading strategy that includes long options, tracking the range of the past year of implied volatility is a fine habit to stick with. That goal is to easily answer one question: “If that option is carrying a threat of volatility crush, what can I do to avoid a loss?”

There was an interesting book published by two fund managers this year that I enjoyed reading. I couldn’t help but chuckle when I read that they made big investments in 2011 in an attractive new stock, Molycorp (NYSE:MCP). They reported that they took a big loss when it only went to a rising price early and then caved in to a much lower price. As an options investor I also entered MCP’s long stock position, yet added options to protect myself. I was given a huge advantage to boost my results with the spike in implied volatility during the year. Although I had bought the stock at $57.70 per share and sold it eleven months later at $29.10, I ended up with a 29% profit by taking advantage of IV in short options. A key thought in position holding is to follow the stock chart daily, review the full risk in the trade, know how to modify the position in order to lower risk, and understand what characteristics will benefit your trade.

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