Option Investor
Educational Article

Volatility Is A Part Of Life Deal With It!

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A little violence in one's life can be very exciting, and profitable. No, I'm not suggesting you go rob your neighborhood liquor store. I'm talking about your trading life. The violence I'm referring to is the up and down fluctuations in the stock market. How severe these fluctuations are is measured by what is called "volatility."
Obviously, when there are dramatic spikes, the volatility can be very high. Conversely, when the stock is moving sideways, and not moving up and down, the volatility is reduced. Remember, earlier we discussed the components of an option price based on the Black Scholes pricing formula. Volatility is one of the ingredients. Basically, increased volatility means there will be a higher premium. Reduced volatility translates into lower premium.

Volatility Good or Bad?

How do we determine if the price of an option is good or bad? Well, it depends on what we're trying to do. If we're buying a put or call option, and we're hoping for a directional move, we don't want to overpay for the option. So, we look for options that are undervalued instead of options that are overvalued. We're essentially looking for a bargain.
When we buy an option, a portion of the price is "time value." We discussed that quite thoroughly in previous columns. This time value will deteriorate during the life of the option. When picking a direction, we're hoping the underlying stock will move in the appropriate direction before all the time value disappears from the value of the option.
Note: Over 80% of options expire worthless. That should tell you a little about your probability of success from straight option buying. We'll go into that later, in depth, and learn how to improve your chances of becoming profitable.

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