by Russ Allen, Online Trading Academy Instructor
This is part of a series on option spreads, which are positions involving more than one option. Options can be combined like Lego blocks to create positions to fit varying market outlooks.
We can assemble the blocks into a position that will be most beneficial if our outlook on the outcome of the three main forces that change option prices is correct. These three forces are:
The actual price movement of the underlying stock. Rising stock prices push call option prices up, and put option prices down. Dropping stock prices do the opposite.
The expected future price movement of the underlying stock. The faster the movement option traders expect in the price of the stock, the more they will pay for options (both puts and calls). As these expectations change option prices inflate and deflate. This effect can happen very fast – in a matter of days or less. And changing expectations can even have a larger effect than that on the actual price movement of the stock. Changing expectations can either augment the effect of the actual change in stock prices or counteract it, sometimes more than cancelling out the effect of price movement. An untrained option trader can be left scratching his head wondering how his call options lost money when the price of the stock went up. In our Professional Option Trader class, we emphasize the importance of this effect, called implied volatility, and make it a central pillar of our option trading method.
The passage of time. This is a relatively easy one to figure. Every option loses a little of its value every day as it approaches its expiration date, and the rate can be easily calculated. This one too can get a little tricky, though, as the rate of decay remains pretty stable for a long time and then suddenly accelerates near expiration.
We can build an option position that is designed to take advantage of any one, or any combination of these three option forces. Here is an example of a situation where we have a strong opinion on the likely direction of stock price movement; but not on whether changing market expectations going forward are more likely to inflate or deflate option prices. We want a position that will make money if the actual price movement is in the direction that we expect; but we don't want to be hurt by changing expectations no matter which way they change.
