OPTIONS PRICING FACTORS AND COMPLEXITIES

Options can be utilized in a plethora of strategies, ranging from very low to very high risk tactics. They can also be customized to meet expectations that go beyond simple linear strategies. When you learn the basics of options trading, it makes sense to investigate the factors and complexities of options pricing.

Options for Directional Styles

When stock  traders first start using options, it is typically to buy a call or put for directional trading, in which they expect a stock will move in  specific direction. These traders may choose an option instead of the underlying stock due to limited risk, high reward potential and less capital that is required to control the same number of shares.

Market Direction and Pricing

Many kinds of options strategies can be created but the position’s success of failure depends on a thorough understanding of the two types of options: the put and the call. Furthermore, taking full advantage of options demands a new way of thinking because traders who solely in terms of market direction miss all sorts of opportunities.

In addition to going up or down, stocks can also move sideways or trend slightly higher or lower for long periods of time. They can also make huge moves up or down in price, then reverse direction and end up back where they started. These kinds of price movements cause frustrations for stock traders but give options traders an exclusive chance to make money even if the stock goes nowhere.

Complexities of Options Pricing

Here are some of the general effects that variables have on the price of an option.

Underlying price

The value of calls and puts are affected by changes in the underlying stock price in a relatively straightforward way. When the stock price goes up, calls should increase in value and puts should go down. Put options should increase and calls should decline as the stock price falls.

Time

Additionally, time’s effect is quite easy to conceptualize but takes experience before understanding its impact due to the expiration of date. This works in the trader’s favor since good companies usually rise in the longer term.

However, time is the enemy of the options buyer since, if days go without a significant price change in the underlying asset, the value of the option decrease. Also, the value of an option will plummet more rapidly as it nears the expiration date. Conversely, that is good news for the options seller, who attempts to benefit from time decay, especially during the final month when it takes place more rapidly.

Volatility

The effect of volatility on an option’s price is the most difficult concept for newbies to comprehend. It depends on a measure called statistical, or historical, volatility, looking at past price movements of the stock over a given period of time.

 Option pricing models require the trader to enter future volatility during the life of the option. Naturally, options traders don’t really know what it will be in the future. They have to guess by working  the pricing model “backwards.”

After all, the trader already knows the price at which the option is trading and can check other variables including interest rates, dividends, and the time left with a bit of research.  As a result, the only missing number will be future volatility, which can be estimated based on other variables and inputs.