36 lines
2.7 KiB
Plaintext
36 lines
2.7 KiB
Plaintext
762 Part VI: Measuring and Trading Volatility
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benefit if implied volatility merely returns to "normal" levels while you hold the posi
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tion. Of course, having the underlying increase in price is also important.
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Conversely, an option seller should be keenly aware of implied volatility when
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the option is initially sold - perhaps even more so than the buyer of an option. This
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pertains equally well to naked option writers and to covered option writers. If implied
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volatility is "too low" when the option writing position is established, then an increase
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(or worse, an explosion) in implied volatility will be very detrimental to the position,
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completely overcoming the effects of time decay. Hence, an option writer should not
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just sell options because he thinks he is collecting time decay each day that passes.
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That may be true, but an increase in implied volatility can completely domin.ate what
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little time decay might exist, especially for a longer-term option.
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In a similar manner, a decrease in implied volatility can be just as important.
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Thus, if the call buyer purchases options that are "too costly," ones in which implied
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volatility is "too high," then he could lose money even if the underlying makes a mod
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est move in his favor.
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In the next chapters, the topic of just how an option buyer or seller should
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measure implied volatility to determine what is "too low" or "too high" will be dis
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cussed. For now, suffice it to grasp the general concept that a change in implied
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volatility can have substantial effects on an option's price far greater effects than the
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passage of time can have.
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In fact, all of this calls into question just exactly what time value premium is.
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That part of an option's value that is not intrinsic value is really affected much more
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by volatility than it is by time decay, yet it carries the term "time value premium."
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TIME VALUE PREMIUM IS A MISNOMER
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Many (perhaps novice) option traders seem to think of time as the main antagonist to
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an option buyer. However, when one really thinks about it, he should realize that the
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portion of an option that is not intrinsic value is really much more related to stock
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price movement and/or volatility than anything else, at least in the short term. For
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this reason, it might be beneficial to more closely analyze just what the "excess value"
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portion of an option represents and why a buyer should not primarily think of it as
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time value premium.
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An option's price is composed of two parts: (1) intrinsic value, which is the "real"
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part of the option's value - the distance by which the option is in-the-money, and (2)
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"excess value" - often called time value premium. There are actually five factors that
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affect the "excess value" portion of an option. Eventually, time will dominate them |