Explore Your Options by Tom Gentile
A CALL ON VOLATILITY
Iím new to options and having some difficulty. Despite the broader market having more or less trended higher since September 2010, Iíve found my purchased calls, which I make sure arenít expensive in their relative historical and implied pricing, are nonetheless resulting in net losses. Any insight into what I might be doing wrong would be appreciated.
First of all, Iím pleased to see youíre learning about the mechanics of option pricing with regards to the influences of volatility. The bad news is when youíre buying an option cheap with no other hedge, that trading edge can be quick to disintegrate as the purchased optionís greeks begin to influence the pricing.
For instance, letís say you bought 10 at-the-money calls two months out for $1.70 per contract. When comparing the price to historical and implied volatility values, you estimate your edge as $0.30 with the call fairly priced at $2.00. The problem with buying the calls on this supposition? You arenít trading volatility at that point. Your ďcheapĒ purchase is inherently flawed almost immediately because youíve left yourself open to delta or directional risk and, over the course of time, theta or time decay as well.