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 the underlying stock price action 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 learning to trade.
The price influence, time, is easily understood; in part because it is the only one of the forces restricted to unidirectional movement. The core reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.
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 the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to price of the underlying and represents the aggregate trader’s 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 traders beginning to become familiar with the world of options trading should direct their attention to understanding the impact of each of these options pricing influences. The options markets are ruthlessly unforgiving to those who choose to ignore the impact of the valuation metrics that underpin daily life in their world.
Edited by John Kmiecik
Senior Options Instructor