V.6:1 (14-17): Trading options volatility by John Nelson and Stephen Kreis

V.6:1 (14-17): Trading options volatility by John Nelson and Stephen Kreis
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Trading options volatility by John Nelson and Stephen Kreis

The objective in trading options is generally a rather straightforward one—buy the premiums low and sell them high. For many traders there is no need to make "option action" any more complicated than that. Other option investors like to take a more in-depth look at the factors that affect the premium level to develop their trading strategies.

Volatility is the most important factor affecting option premiums. In fact, some traders only take positions based on volatility, and are always neutral with respect to price. Knowing volatility and successful options trading go hand in hand.

Volatility describes how fast and how much prices change. A price series with high volatility is one which has large and fast price movements. A low volatility price series has small and infrequent price changes.

In Figure 1, price series A is more volatile because the price changes are much larger than price series B. When looking at volatility, the actual price level and direction are not important. What is important is the size and rate of price change.

What does this mean to the option trader? An option with a higher volatility will have higher premiums—prices—than an option with lower volatility. When futures prices are moving around a lot, as in prices series A, there is a higher probability that an option will become in the money—rise above its strike price. Therefore, option sellers demand higher premiums to compensate for the greater risk of ending up with a losing position. Options buyers are willing to pay more, because their positions will be more likely winners in a moving market.

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