How Volatility Affects Option Prices
As prices of stocks, commodity futures, and foreign currency pairs fluctuate, so do prices of options traded on these items. How volatility affects option prices is by the rising of option prices for puts and calls at all strike prices as volatility goes up. Traders follow measures of implied volatility such as the CBOE volatility index, the VIX. The reason that option prices go up with volatility is that rising volatility increases the likelihood of options contracts finishing in the money.
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What Is the Limit Price on a Call Option?
Options prices fluctuate over time and can fluctuate quite violently when the market for the underlying is volatile. Option traders commonly set a limit price, also called a limit order, in order to specify the maximum price that the trader will pay to purchase an option contract. When selling an option contract the limit price specifies the minimum that the trader will be willing to receive. This approach ensures that an option trader will not get into a trade at a disadvantageous price.
What Is a Strike Price in Option Trading?
In option trading traders buy or sell calls or puts. A call gives the buyer the right to purchase or sell a stock, futures contract, or foreign currency at a given price. This price is called the strike price. The buyer of a put or call contract may choose to buy or sell when the underlying reaches the strike price and the seller is then obliged to fulfill their side of the bargain. More commonly a trader will simply close the trade for a profit by executing the reverse trade.
What Happens When a Call Option Hits the Strike Price?
What happens when a call option hits the strike price depends on the trader who purchased the call or put contract. An investor may buy a call on a stock in hopes of getting into a long term investment at a lower price. They will pay to buy at the set price even when the market goes higher. The seller is obliged to sell no matter the amount of loss that they may incur. A trader generally has no interest in holding the stock and will simply close the contract for a profit at this point.
How to Pick an Option Strike Price
Choosing a strike price for buying or selling a call or put depends on where a trader believes the price of the underlying stock, futures, contract, or currency pair will go during the term of the option contract. In a bull market a trader will commonly choose a higher strike price for buying a call contract than if the market is falling. In a falling market a trader selling puts will generally choose a lower strike price than when trading in a sideways trading market. Traders typically use market indicators to help predict price movement.
How to Predict an Option Price
As stock prices rise and fall, so do option prices. However, there is not a one to one correlation. Traders commonly use “the Greeks” to predict option price. For example, a delta calculation helps traders predict how much an option price will move in response to a one dollar movement in the underlying security. A delta for a call is a positive number and a delta for a put is a negative number. The possible results range from zero to one for calls and zero to minus one for puts.
Does Option Trading Affect Stock Prices?
As we noted, a useful measure of implied volatility is the VIX. This index is based on near term calls and puts. It is referred to as the fear index because it goes up when the market is scared and volatility is high. While the VIX is a measure of concern in the market it also drives buying and selling because investors and traders follow the VIX and use it to guide their actions. Thus the VIX tends to move quickly to a peak and then gradually subside unless other factors intervene to further spook traders.
What Is the Exercise Price of an Option?
The exercise price of an option contract is the same as the strike price. It is known when the contract is bought or sold. The value of an option as the market moves from day to day is determined by the difference between the exercise price, which is fixed, and the market price which varies. Whether an option is “out of the money” or “in the money” is determined by the relation between the market price of the underlying and the exercise price.
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Originally published at https://daytradesafe.com on September 21, 2022.
