Options traders consider a number of variables when deciding when to buy and sell contracts. Because options contracts guarantee the right to trade an asset at a specific price for a certain period of time, their price depends in large part on the perceived value of the underlying security and the length of time before the option expires. Traders should thoroughly understand the influence of these factors on option prices, especially when trading on downward-oriented put options.
Options Pricing Basics
A put option guarantees the holder the right -- but not the obligation -- to sell a given security at a particular price, known as the strike price. The option lasts for a particular period of time, then expires. Because they offer the right to sell, put options are more valuable when the underlying asset price is falling. Option prices are derived from a number of factors. Some of these are stable, such as the price of the underlying asset, the strike price and the current interest rate. All options include an element driven by supply and demand, known as the implied volatility.
Implied volatility is the market's estimate of future price movement. Volatility measures the amount and frequency of option price changes -- how likely it is that the option price will change dramatically in the near future. Implied volatility is driven by investor uncertainty: The more that is unknown about the value of the underlying asset, the more opportunity there is for the price to move in the option holder's favor (down, in the case of puts) and the more traders are willing to pay for that potential.
Each option contract has a specific maturity or expiration date. As an option gets closer to its expiration date, the less opportunity there is for price change. This decreases uncertainty. If a put option is in-the-money -- that is, the strike price is higher than the underlying asset price -- the price will go up. If the put is out-of-the-money -- the strike price is lower than the asset price -- the put will become worthless. In general, option prices go down over time, a phenomenon known as time decay.
Relationship of Time Decay and Implied Volatility
Time decreases uncertainty, which in turn decreases implied volatility. Even on in-the-money options, this can result in a lower option price. In some circumstances, this phenomenon can result in a trader losing money on an in-the-money option if that trader deals exclusively in options contracts and does not trade underlying assets. Traders can recover some of their profit if they are able to purchase the underlying asset, then exercise the put to sell at a higher price. In this case, time erodes profit but is less likely to result in an actual loss.
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