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Three Things You Should Know About Options Valuation


It's about more than levering up with puts and calls.

Some traders use options to speculate on the price movement of an underlying asset; other traders use options to speculate on changes in the volatility, implied or realized, of that asset.

Put a little differently: While no options trader can afford to ignore the role that volatility plays in the price of a contract, not all options traders are interested exclusively, or even primarily, in volatility. If you're essentially a stock picker who likes to lever up by buying puts and calls in Apple (AAPL), RIM (RIMM) and the like, you know that there's another type of options trader who does something very different.

There are 3 components that affect the value of an option: price, time, and implied volatility. (Of course, interest rates and other carrying costs matter, too -- but not nearly as much.) Changes in the price of the underlying asset will affect the price of an option on that asset, as will the passage of time, and changes in expectations of future volatility.

We measure the exposure an option contract has to these 3 components and report them as the "greek" (as opposed to Greek) variables: delta, theta, and vega. (You'll note that vega isn't in the Greek alphabet.)

Now, if you're an options trader of the second type -- i.e., not just a stock-picker on steroids -- and you have a view to express about volatility, then you'll want to reduce your exposure to other irrelevant variables. It's like running a business: If you're one of the biggest and best insurance companies around, then -- if you're smart -- you'll think twice before risking your entire company on your ability to make hamburgers or to sell over-the-counter credit derivatives. (Derivatives aren't actually all that different from fast food: You put a lot of nasty stuff in a sack, and hope not to hear from your buyers anytime soon.)

That's why options traders and authors in academic finance journals spend so much time thinking about delta hedging. It's actually not an optional strategy, if you'll pardon the pun. Hedging away unwanted risks is a key survival tactic. Traders are only profitable to the extent that they can reduce or eliminate the impact of variables besides volatility. Delta hedging of some form or another is a necessary, but not sufficient, condition for successful options trading.
No positions in stocks mentioned.

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