You can be right on the direction of the stock and give yourself enough time for it to play out and still lose money if you don’t get this right. The second biggest mistake options traders make is not taking into account where the underlying stock or commodity is in its natural fluctuations. This will all become clear in a minute.
There are five pieces of information that fix the price of an option. Four of them are open for anyone to see. They are the price of the underlying stock or commodity, the strike price of the option, the time to expiration of the option, and the interest rate. The last hidden variable is the most important – the implied volatility.
Volatility is how much the price moves around. If the price were fixed, the volatility would be zero. If the price bounced wildly the volatility could be 100%. With the large drop in the stock market last fall, all volatilities have increased. The market as a whole has a volatility, measured by the VIX , of 40%. This measures the expectations of traders for the fluctuations of the market.
Last fall, the VIX hit 100%
The highest reading ever.
To have the best chance for a trade to pay off, you have to see where you are in the volatility cycle. Is the volatility relatively low for Apple? Maybe that means it is a good time to buy options. Is the volatility relatively high for Apple? Then you want to sell options.
Nice writing style. Looking forward to reading more from you.
Chris Moran