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The market is getting ready to kick off another roller coaster ride…
If you've kept an eye on the news lately, then you know what I'm talking about. There are a ton of drivers pulling stocks back and forth right now.
Third-quarter earnings reports are being released every day, public impeachment hearings drag on, the trade war is barreling on without a deal – and to top it all off, the holidays are about to hit.
There's something brewing in the market right now, and it's about to explode – and even experienced traders don't know the truth behind it.
Today, I want to share something with you that most traders don't know. It's one of the biggest secrets in the world of options…
And this is how it could drop some serious cash in your pocket…
Options are comprised of two kinds of value: intrinsic and extrinsic (also called real and time value, respectively).
This value goes into how an option is priced – and more importantly, it's an essential part of your own profit-taking strategy.
Now, most traders don't know this, but an option's extrinsic value includes more than just time value…
It also contains something called "implied volatility" (IV).
Extrinsic Value = Time Value + Implied Volatility (IV).
An option's IV can fluctuate wildly – and that translates directly to wild fluctuations in price.
The general rule of thumb is that a 1% change in IV translates to a 1% change in the option's price.
So, if you buy an option and the IV of the option drops 20%, your option will drop 20% as well, even if nothing else changes.
Of course, the opposite is true as well.
Clearly, it's critical to understand IV and, in particular, what the IV of an option is before you buy it.
Let's take a look at an example. Below is an IV chart for TripAdvisor Inc. (NASDAQ: TRIP).
The green "E" triangles are earnings announcements. The red line is the amount of IV in TRIP options. As you can see, IV consistently runs up into earnings, meaning that TRIP options become more expensive – something we've talked about before.
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.