The Volatility of Stock Options
Stock options are publicly traded contracts that you may buy and sell much like stock. But although stock options are based on actual stock prices, they are much more volatile than stocks, and it is possible to quickly lose most of your investment in them. Many factors affect the behavior of option prices, and anyone who plans to trade stock options must understand how option prices fluctuate before purchasing contracts.
Other People Are Reading
-
Contract Structure
-
A stock-option contract affords its owner the right to buy or sell 100 shares of a stock at a locked-in price at any time before the contract expires. For example, a "call" option may let you buy 100 shares of stock XYZ for $20 per share at any time before the option expires in three months. If the share price of XYZ rises by $1 at any time, then technically the option is worth an extra $100, or $1 times 100 shares. If you paid only $100 for the contract, then this increase amounts to a 100% gain from only a $1 change in XYZ's share price. This example demonstrates "leverage," or the ability to control large assets for a small upfront sum, and this is one reason options are so volatile: When stock prices move quickly, option prices can make a hundreds- or even thousands-of-percent leap.
Time Decay
-
An option that expires much further into the future will cost more than an option that expires next month, even if the terms of the contract are otherwise the same, because the longer contract affords you more time for the stock to move favorably. But this "time value" diminishes as the expiration date approaches. This phenomenon, known as "time decay," is an important influence on volatility. Options quickly lose money if a stock fails to move favorably and they face imminent expiration. After expiration day, all options are worthless.
-
Stock Volatility
-
The volatility of a stock option comes in part from the volatility of the underlying stock. Some stocks fluctuate more dramatically than others, and the prices of options based on these stocks must account for this volatility so that the options fluctuate in a manner consistent with the stock's historical volatility. If the stock's inherent volatility changes for any reason, the option's volatility will also change. This aspect of stock-option pricing, called "implied volatility," affects how professional stock-option traders evaluate a fair price for options.
The VIX
-
Stock-option volatility affects more than just option traders. Calculated at the Chicago Board Options Exchange, the Volatility Index, or "VIX," is a measurement of stock-index option trading to objectively quantify the overall volatility of the stock market. Index options are one type of stock option, and rather than control shares of stock, these contracts instead control cash bets on the direction of an entire stock-market index, such as the S&P 500. The VIX, sometimes called the "fear gauge," monitors the volatility of index options. It rises when option-trading activity indicates that professional option traders are hedging against a decline in stock prices. A rising VIX often corresponds with an overall stock-market decline and tends to accompany increased volatility throughout the financial markets.
Warning
-
The immense volatility of stock options makes them a highly risky way to participate in the financial markets. New option traders should avoid trading short-term options that expire in a short time, because it is very challenging to profit in the face of time-decay volatility. Never place as much money into an options trade as you would a stock trade. In return for potentially great profit rewards, you must endure extreme risk.
-
