SPX It is hard to endorse one strategy over the other in this environment, but discipline and due diligence is of the essence While option prices are based off stock prices, option and stock trading are two very different things. A buy and hold long-term investor does not have to worry about volatility.
Option traders, on the other hand, need to be mindful of expiration dates, making volatility key. Option prices consist not only of intrinsic value, but also of time value. The time value varies from stock to stock, but it determines the implied volatility. The stock move must overcome this time value for the option to make a profit, and the move must occur before the expiration date. Established large-cap companies typically have cheap options, while smaller, more speculative companies generally have expensive options.
The example below clarifies that point.
The Dangerous Lure of Cheap Out-of-the-Money Options
The implied volatility on the LYV call option is two and a half times the implied volatility on the KO call option.
For LYV, however, the required stock move is more than three times that amount, at 6. In other words, there is a higher probability of a big stock move in LYV.
That is the trade-off option players make. They can buy a low-priced option that profits handsomely on a why options are so cheap small move by the stock, or they why options are so cheap buy a high-priced option on a stock that needs to make a sizable move, but the potential for that sizable move is greater. In the analysis below, I show the challenges that high implied volatilities present option traders to see if one of those trade-offs has worked out better over the past year.
Stock Trading vs. Option Trading The table below perfectly sums up the difference between option trading and stock trading. It also shows the massive effect of option prices on option returns.
The trading environment, however, was completely different. In Decembermarkets were relatively calm and had been steadily climbing for a few months.
"When is an option expensive or cheap?"
Option prices, therefore, have been much more expensive. Finally, we can take a look at these numbers. Holding the stocks, a trader would have gained about 2. Now, look at the average return on the call options.
How to Find Cheap Options For Options Trading
This demonstrates the leverage you can gain using options. In other words, doubling of the implied volatilities was extremely damaging for the option returns. I mentioned the trade-off between cheap and expensive options earlier.
Cheap options require less of a move from the underlying stock to get a positive return when compared to more expensive options. The more expensive options, however, are on stocks expected to make bigger moves.
"When is an option expensive or cheap?" by samuray-club.com Answers
The table below compares cheap options to expensive options over the past two expiration cycles again, 16 trading days before the expiration date. The group of stocks with expensive options had the best stock return, averaging a gain of 3.
Since the market has gone up over these time periods, you would expect the expensive options to have better returns. The expensive options, however, lost the least amount per trade. What is clear, however, is that it has been a difficult trading environment for option traders, so discipline and due diligence is of the essence. Don't Miss Any Updates!
Implied Volatility Explained - Options Trading Concept
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