33 lines
2.2 KiB
Plaintext
33 lines
2.2 KiB
Plaintext
Supply and Demand: Not Just a Good
|
||
Idea, It’s the Law!
|
||
Options are an excellent vehicle for speculation. However, the existence of
|
||
the options market is better justified by the primary economic purpose of
|
||
options: as a risk management tool. Hedgers use options to protect their
|
||
assets from adverse price movements, and when the perception of risk
|
||
increases, so does demand for this protection. In this context, risk means
|
||
volatility—the potential for larger moves to the upside and downside. The
|
||
relative prices of options are driven higher by increased demand for
|
||
protective options when the market anticipates greater volatility. And option
|
||
prices are driven lower by greater supply—that is, selling of options—when
|
||
the market expects lower volatility. Like those of all assets, option prices
|
||
are subject to the law of supply and demand.
|
||
When volatility is expected to rise, demand for options is not limited to
|
||
hedgers. Speculative traders would arguably be more inclined to buy a call
|
||
than to buy the stock if they are bullish but expect future volatility to be
|
||
high. Calls require a lower cash outlay. If the stock moves adversely, there
|
||
is less capital at risk, but still similar profit potential.
|
||
When volatility is expected to be low, hedging investors are less inclined
|
||
to pay for protection. They are more likely to sell back the options they may
|
||
have bought previously to recoup some of the expense. Options are a
|
||
decaying asset. Investors are more likely to write calls against stagnant
|
||
stocks to generate income in anticipated low-volatility environments.
|
||
Speculative traders will implement option-selling strategies, such as short
|
||
strangles or iron condors, in an attempt to capitalize on stocks they believe
|
||
won’t move much. The rising supply of options puts downward pressure on
|
||
option prices.
|
||
Many traders sum up IV in two words: fear and greed . When option
|
||
prices rise and fall, not because of changes in the stock price, time to
|
||
expiration, interest rates, or dividends, but because of pure supply and
|
||
demand, it is implied volatility that is the varying factor. There are many
|
||
contributing factors to traders’ willingness to demand or supply options.
|
||
Anticipation of events such as earnings reports, Federal Reserve |