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Last week, I gave you an in-depth look at delta, a major component of options pricing that can tell you how much your option will move in relation to moves in the stock price.
But there are a few more "Greeks" you'll need to know if you want to be successful at options trading.
If you've been with me for a while, then you know that volatility has a huge impact on options pricing, but we haven't really covered the mechanics of how that happens, or what it means for your money.
Understanding today's lesson is crucial – I'm going to show you how to find stocks with a chance to make big moves… and how to identify potentially lucrative options plays to profit on those moves.
We're going to explore in detail the Greek that measures changes of an option's value based on how much the implied volatility (IV) on the underlying security changes.
Let's take a look…
Real Value vs. Time Value
An option premium has two primary components to it: intrinsic value and extrinsic (time) value.
Intrinsic value, also called real value, is the amount an option is in the money (ITM).
For example, if a stock is trading at $47, then a $45 call option would be ITM by $2.00.
The reason it is deemed ITM is because the strike price is less than the stock price, which means the call option has real value of $2 because the call option allows the buyer the right to buy the stock at $45 while it's selling on the open market for $47. That's a built-in profit, or intrinsic value, which is governed by delta.
Now, technically there may not be an actual realized profit because the option would cost a bit more than $2 thanks to the extrinsic value component.
Extrinsic value is the amount of the premium that is paying for the time value of the option. If an option is ITM, it has both intrinsic value and extrinsic value until expiration. Out of the money (OTM) options, however, have no intrinsic value – 100% of an OTM option's value is extrinsic.
The extrinsic value of an option is determined by the implied volatility (IV) of the underlying, which is measured by the options Greek known as vega.
Vega is a calculated value showing the theoretical change in price for an option for every 1% change in volatility in the underlying asset.
Take for example an option that is trading at $3.00 with a vega of 0.15, or 15%. When the IV goes from 24% to 25%, the option, on vega alone, should theoretically increase to $3.15.
When IV rises, the option price rises along with it and vice versa.
IV has an effect on the price of options as it estimates the potential magnitude of a move in a security in either direction. It's what the markets believe an underlying asset's historical volatility will be going forward based on changes in the options price.
About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.