One of the biggest factors that go into option pricing is implied volatility. This fact is often underappreciated by newcomers to options trading.
It can also lead to some nasty surprises if it isn't suitably taken into account.
Beginners in option trading are often enticed by the ability to take long positions on stocks with a lower cash outlay than would be necessary than buying the stock outright. They may realize the time risk from the option expiration date, but within those confines, they view call options as equivalent to buying a stock.
This isn't true of course. Implied volatility plays a huge role in the pricing of options, and changes in implied volatility can have just as big of an effect on the price of an option as changes in the underlying stock price.
Because of this, it's often possible that one could guess right on the direction of the stock, but still lose money. They buy a call, see the stock rise before their call's expiration date, but still lose money on the trade. They are left scratching their heads, wondering what happened.
Almost invariably, the answer is related to implied volatility.
There is a premium priced into an option that takes into account the underlying asset's implied volatility. This is referred to as the "volatility premium." Simply put, implied volatility can be seen in option pricing as the potential for significant changes in the future. If you knew for certain that a stock was going to trade at the same price every day until expiration, options would revert to their intrinsic value -- that is, the difference between the stock price and the strike price. But as volatility goes up, the potential for that option to have more value in the future goes up.
So as implied volatility rises, the options price benefits. If it goes down, it drags on the price of the option.
This can lead to complicated results as changes in the price of the underlying asset and changes in the implied volatility both work on an option's price.
In order to see how this works, first a quick review: generally speaking, puts and calls are used to make opposite bets on the direction of an underlying asset. A call benefits when the price of the underlying asset rises, while a put benefits if the price falls.
As we've noted, the dynamic is different for implied volatility. Both calls and puts react similarly to changes in implied volatility.
For both puts and calls, a rise in implied volatility has a positive impact on the price. Meanwhile, a fall in implied volatility has a negative impact on both types of options.
This means that a call benefits most when both the price of the underlying asset and its implied volatility go up. Calls see the biggest negative impact from a decline in both.
For puts, the effects are split. If an investor is holding puts, the best situation would be for the underlying asset to fall in price, while implied volatility rises. On the other hand, a rise in the price of the underlying asset and a fall in implied volatility would have the biggest negative impact on the put.
Given that implied volatility is a key component of option pricing, it is important to take it into account when making an option bet. Investors should check implied volatility while weighing the decision to make an options trade.
In addition, there are strategies that can be used to hedge against this risk.