Options are derivative contracts that give the buyer the right, but not the obligation, to buy or sell the underlying asset at a mutually agreeable price on or before a specified future date. Trading these instruments can be very beneficial for traders. First, there is the security of limited risk and the advantage of leverage. Secondly, options provide protection for an investor's portfolio during times of market volatility.

The most important thing an investor needs to understand is how options are priced and some of the factors that affect them including implied volatility. Option pricing is the amount per share at which an option is traded. Although the option holder is not obligated to exercise the option, the seller must buy or sell the underlying instrument if the option is exercised.

Learn more about options, and how volatility and implied volatility work in this market.

Key Takeaways

  • Option pricing, the amount per share at which an option is traded, is affected by a number of factors including implied volatility.
  • Implied volatility is the real-time estimation of an asset’s price as it trades.
  • When options markets experience a downtrend, implied volatility generally increases.
  • Implied volatility falls when the options market shows an upward trend.
  • Higher implied volatility means a greater option price movement can be expected.

Options

Options are financial derivatives that represent a contract by a selling party—or the option writer—to a buying party—or the option holder. An option gives the holder the ability to buy or sell a financial asset with a call or put option respectively. This is done at an agreed price on a specified date or during a specified time period. Holders of call options seek to profit from an increase in the price of the underlying asset, while holders of put options generate profits from a price decline.

Options are versatile and can be used in a multitude of ways. While some traders use options purely for speculative purposes, other investors, such as those in hedge funds, often utilize options to limit risks attached to holding assets.

Options Pricing

An option's price, also referred to as the premium, is priced per share The seller is paid the premium, giving the buyer the right granted by the option. The buyer pays the seller the premium so he has the option to either exercise the option or allow it to expire worthless. The buyer still pays the premium even if the option is not exercised, so the seller gets to keep the premium either way.

Consider this simple example. A buyer might pay a seller for the right to purchase 100 shares of Company X's stock at a strike price of $60 on or before May 19. If the position becomes profitable, the buyer will decide to exercise the option. If, on the other hand, it does not become profitable, the buyer will let the option expire, and the seller gets to keep the premium. 

There are two facets to the option premium: The option's intrinsic value and time value. The intrinsic value is the difference between the underlying asset's price and the strike price. The latter is the in-the-money portion of the option's premium. The intrinsic value of a call option is equal to the underlying price minus the strike price. A put option's intrinsic value, on the other hand, is the strike price minus the underlying price. The time value, though, is the part of the premium attributable to the time left until the option contract expires. The time value is equal to the premium minus its intrinsic value.

There are a number of factors that affect options pricing including volatility, which we'll look at below.

Other factors that affect options pricing include the underlying price, strike price, time until expiration, interest rates, and dividends. 

Implied Volatility

Volatility, in relation to the options market, refers to fluctuation in the market price of the underlying asset. It is a metric for the speed and amount of movement for underlying asset prices. Cognizance of volatility allows investors to better comprehend why option prices behave in certain ways.

Two common types of volatility affect option prices. Implied volatility is a concept specific to options and is a prediction made by market participants of the degree to which underlying securities move in the future. Implied volatility is essentially the real-time estimation of an asset’s price as it trades. This provides the predicted volatility of an option’s underlying asset over the entire lifespan of the option, using formulas that measure option market expectations.

When options markets experience a downtrend, implied volatility generally increases. Conversely, market uptrends usually cause implied volatility to fall. Higher implied volatility indicates that greater option price movement is expected in the future.

Another form of volatility that affect options is historic volatility, also known as statistical volatility. This measures the speed at which underlying asset prices change over a given time period. Historical volatility is often calculated annually, but because it constantly changes, it can also be calculated daily and for shorter time frames. It is important for investors to know the time period for which an option’s historical volatility is calculated. Generally, a higher historical volatility percentage translates to a higher option value.

Option Skew

Another dynamic to pricing options, particularly relevant in more volatile markets, is option skew. The concept of option skew is somewhat complicated, but the essential idea behind it is that options with varied strike prices and expiration dates trade at different implied volatilities—the amount of volatility is uniform. Rather, levels of higher volatility are skewed toward occurring more often at certain strike prices or expiration dates.

Every option has an associated volatility risk, and volatility risk profiles can vary dramatically between options. Traders sometimes balance the risk of volatility by hedging one option with another.