Option trading remains a mystery to many new traders. There are elements to option trading that traders should know about to make trading easier. In this article, I give an example of how an options trader might use implied volatility in his trading. Then, I discuss implied volatility charts and how they are created.
There is a definite connection between time value and volatility. As an option moves further away from its strike price time value decreases. Since the option has less time value, it will also have lower implied volatility. In making this observation, we can see the link between the volatility and time value. Once we understand this relationship, we can use this to our advantage in our option trading. So, let's look at an example of how this might be useful.
Let's suppose that we have a calendar spread on XYZ stock. To create the spread, we sold the December 50 call for $2.00 and purchased the March 50 call for $4.50 when the stock was at $50. The net result is a debit of $2.50 to our account. Typically, traders like to place his type of trade when the volatility in the options sold is higher than the volatility of the options purchased. All things being equal, this lets them know that they are selling more time value than they are purchasing. Traders sometimes refer to this as volatility skew.
Now, let's say that after we place our calendar spread the stock begins to move up. As it does, the intrinsic value of our options increase and the time value of our options decrease. So, let's say that we have about two weeks left before the December 50 call options expire and the stock has moved up to $55. The December 50 call options are trading for $5.75. This means that the time value of this option has decreased by $1.25 while the intrinsic value has increased five dollars.
If we allow the December 50 call option to remain in the money, it is likely that we will be exercised at options expiration. Also, as the option's time value continues to decrease, it also increases the likelihood that the option will be exercised. In order to prevent this from happening, the trader could purchase the December 50 call option initially sold while selling an option with more time value.
Suppose the trader purchases the December 50 call option for $5.75 and sells the February 55 call option for $5.70. The result is a net debit to the account of five cents. So, we collected $1.25 of time value on the December 50 calls and sold an additional $5.70 worth of time premium when we sold the February 55 call options. This means that we collected a total of $6.95 of time premium. As with the options example from last week, this was accomplished by covering the option after its time value and volatility had decreased due to market movement and selling an option that has more time value and higher volatility.
Implied Volatility charts
Novice traders sometimes look at implied volatility charts without really understanding how they are created. This usually comes to light as they begin to realize that volatility can be calculated for any option. And, the volatility value will likely be different for each option. So, if this is the case, where does the implied volatility value come from that is used to create these charts?
Typically, implied volatility charts are created by using options which are at the money and will expire within the next 30 days. So if we look at the last point on a implied volatility chart, the volatility value would be derived from the option that was at the money as of the close of the trading day.
For example, let's suppose that we are looking at an volatility chart for XYZ Company. Today XYZ Company closed at $25. If we use and options pricing model on the $25 option, we can derive the volatility. If we do this every day, we can create a chart of daily implied volatility.
A good understanding of volatility is important to option trading. Seasoned options traders understand how to use implied volatility to consistently make money. Once you understand what it is and how to use in option trading, you can take steps to place the odds of making money in your favor.
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