There are 4 top challenges facing option buyers in the stock market. Anyone looking to gain long term success with options should have these questions answered before they use them.
1. Time decay. When you buy an option there is both time value and intrinsic value in that option price. Intrinsic value moves the option based on the price of the stock. Time value goes down slowly as the option price gets closer to expiration. Because of this an option buyer needs to have the intrinsic value go up faster than the time value to make any money.
If they intrinsic value doesn’t go up fast enough have this the stock could do what they wanted it to do and they still lose money. The best way to combat this problem is to buy more time value. If you have an option 3 months out the time value will decay at a much slower rate than an option that is 1 month away from expiration.
2. The Bid and ask price also pose a problem for option buyers. When buying options there are two prices the bid and ask. The ask price is the price that you can buy it for and the bid price is the price that you can sell it for. The difference between these numbers is called the spread.
The price you can buy an option for is always higher than the price you can sell an option for. You need the option to go up above this gap in order to make money. This problem is lessened by not trading options with stocks that have a high spread. Obviously if you find a stock that has an ask price of $8 and a bid price of $6 that might not be a good buy regardless of the stock.
3. The implied volatility. This is very important to understand. The IV measures how volatile the stock is at a given time. It is also used to measure the volatility of an option. This can affect the price because if you buy a call with high volatility the stock can go up but if volatility drops your option’s price will be affected. Now on the same note if you buy a call when volatility is low and the stock price goes down you might still be able to make money if the volatility goes up.
Generally volatility goes down when stocks goes up and it goes up when stock prices fall. You may also want to check the VIX which shows the volatility of the SPY. In addition if you can go to a website like ivolatility.com which will give you the volatility of individual stocks.
4. Delta. Many option traders believe that if a stock moves $1 the option should also move $1. Nope. This is one of the biggest misconceptions new traders have about options. They will not move up exactly the same amount as the stock. In fact there is an option greek called the Delta that is designed to determine how fast an option should move. If the Delta is $.5 then it will move $.5 for every $1 the stock moves.
The farther in the money you buy a stock option at the higher the delta will be. But it will also result in a higher option price as well.
For more information about the stock market visit http://www.stocks-simplified.com