• About
  • Advertise
  • Guest post
  • Contact
  • Privacy policy

Make Money Your Way

Choose the way. Earn more. Start today.

How are Options’ Prices Structured

February 28, 2014

Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options

Prices Structured

In the previous post I discussed the basics of options. The price of an option is essentially the premium that you pay for the option (whether it be a call option or a put option). Below are the factors that affect the premium (aka option’s price). Obviously, you want the premium to be as cheap as possible, thereby increasing the probability of making a profit on your investment.

Time

Every single option, whether call options or put options, has a time factor. An option will expire on a certain date that’s determined by mutual agreement between the option seller and the option buyer. This time factor also affects the option’s premium.

The premium of an option is based on a simple mathematical formula: the square root of time (how long before the option expires). Thus, as time goes on, the premium you pay (as an option buyer) increases at an ever slowing rate. This right here is the assumption behind options, which is something that you (the option buyer) can exploit.

Keep in mind that the premium is meant to protect the option seller (and hurt you, the option buyer). This basic assumption implies that:

Over the long term, the market is neutral. Gains will be offset by losses, and losses will be offset by gains. Thus, it is ok for premiums to increase at a slowing rate (the slope decreases) b/c the risk also increases at an ever slowing rate.

Thankfully, this assumption is just plain wrong. Or else trends wouldn’t exist! And since we know that (obviously) trends do exist, we can exploit this assumption to our own benefit. For example, commodities have been in a bullish trend over the past 13 years. Whoever sold commodity call options would have lost a lot of money over the last 13 years!

Thus, it is evident that long term options (1 year – 5 year) options relatively speaking become cheaper and cheaper (because time is square rooted). That’s why long term options are generally much cheaper than short term options and why, generally speaking, long term options are much better investments.

Volatility

The definition of volatility is simple: how much has the price of a market been fluctuating recently? The larger the fluctuations, the higher the volatility. The smaller the fluctuations, the lower the volatility.

The second component that affects an option’s premium (besides the time until expiration) is volatility. This is actually quite simple to understand – the more volatile prices are recently, the higher premium you (as the option buyer) will be required to pay. The smaller volatility has recently been, the lower the premium you will pay. Why?

Because from a pure theoretical risk management standpoint, volatility = risk. The theorists assume that present low volatility will result to future low volatility. In other words, they extrapolate the present low volatility into the future. We’ll see why that is not true in reality.

Theoretically speaking, low volatility equals to low risk to the option seller. Thus, options are cheap to buy when volatility is low. However, volatility is usually lowest (option premiums are cheapest) near the end of a bull market, when every person out there is a blindly bullish (a.k.a. the market is in a bubble). Thus, in reality low volatility actually equals high risk. When volatility is low, you know that the market is in a bubble and sooner or later, the bubble is going to burst and all the bulls are going to be in a ton of pain.

Thus, the time when volatility is low and options are cheap is exactly when risk is the greatest. Low volatility does not equate to small risk. It equates to large risk (because the bubble is about to burst).

The most common measurement of volatility if VIX, an index created in 1985. Its sole purpose is to measure the amount of “fear” or “volatility” in the market.

Pin5
Share2
Tweet
8 Shares

Filed Under: Investing

« Previous post
Next post »

Lovely comments

  1. DC @ Young Adult Money says

    February 28, 2014 at 6:29 am

    This brings me back to Derivatives class my senior year of college. I was talking to someone this week about trading options. I definitely plan on looking into it more in the future.
    DC @ Young Adult Money recently posted…The Weekly Quick Hits RoundupMy Profile

Trackbacks

  1. The One Problem With Contrarian Investing - Reach Financial Independence says:
    December 17, 2014 at 3:31 am

    […] in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not […]

  2. Investing for Beginners Part 2 – Different Investment Strategies says:
    January 13, 2015 at 7:49 am

    […] Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured […]

  3. The One Problem With Contrarian Investing says:
    March 8, 2015 at 9:12 pm

    […] in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not […]

Subscribe by email!

Enter your email address:

Airbnb voucher code

follow MMYW in feedly

Follow MMYW on Bloglovin

RECENT POSTS

  • 3 Ways to Use Your Unlimited PTO
  • 6 Essential Benefits and Perks You Should Look for When Applying for Jobs
  • Taking care of yourself while working on your side hustle
  • 4 Types of Properties You Can Invest In For Profit
  • What to do when there is no money?
Peratree Investment Philippines

Worth Reading

  • How I made $1,500 renting my house to travelers
  • Make money with your parking space
  • Achieving a 100% saving rate
  • Discover new ways to make money from home
  • How does currency trading work?
  • Archives


    Thank you for reading! Please let me know your thoughts in the comments below. Never miss another post and subscribe via Pinterest RSS feed or email. Or come and say hi on Facebook and Twitter

    Copyright © 2023 Make Money Your Way · Site by Moonsteam Design