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Tilting at Windmills: Understanding the unseen Influences on Your Options
The famed Don Quixote of classic literature battled with unseen enemies, tilting at windmills while gaining the
sympathy of readers around the world. In option trading, we tilt against windmills and invisible enemies, but
they are not imaginary. Like the wind, which can be felt but not seen except by its influence, option volatility
influences the price of all options and it is inextricably connected to the cost of time.
In the end, all you are really paying for in an option is time. If you go out far enough in the future, the
option is free (meaning it has no value) and if you go far enough away from the price of the underlying (in or
out of the money) there is no cost to the time. Note that if you buy in the money, you are simply buying fixed
equity ($2 in the money costs $2). The only variable in the price of an option is the cost of time.
The Black-Scholes binomial option calculation won a Nobel Prize for its ability to accurately predict the cost
of creating an option. Assuming that you understand the basic concept of an option, the calculation of the value
for any option is fairly simple. You are calculating the risk to the person who creates the option, which is to
guarantee the price of some security or transaction for a specific period of time.
For example, if you want to buy a $100 watch, it costs $100 unless you want to have the right to buy it at
$100 for the next month. To freeze the price for a month there will be an additional charge to cover the risk to
the seller, just as there is a fee attached to the right to purchase real estate at a fixed price for the next
six months. In theory, the Black-Scholes model is very simple. While it has four variations, the simplest
version uses five data points and solves for X. Here is a simple entry form to get an option price.
It looks benign, but behind it is an intimidating (to most humans) binomial equation:
This equation determines the price of an option and has proven to be extremely accurate. However options
traders are often frustrated by the movement of option prices that seem to defy common sense. The pricing
structure seems to go crazy in times of volatility. Option prices can become very expensive and the movement of
options relative to the movement of underlying stock seems to be totally out of sync.
Beginning traders will see inconsistencies that make them think, "the option gods are conspiring against me."
Stocks will move and the options will either move faster or much slower than expected, leaving beginner traders
to believe that a little man behind the green curtain (the Wizard of Oz) is out to get them. Traders must
remember that option prices are constantly being adjusted to the current surrounding conditions. Volatility in
the market increases risk and the only component in the options model that is variable is the cost of time. All
other components are fixed. In an equation, if you change one of the components, you change the answer. If you
change the volatility in an option, you change the price and the behavior.
What traders cannot see is the constant adjustment of their option prices to current perceived risk. For
example, take the volatility of either a stock or the general market or both. While it may seem that we are
tilting against windmills that appear and disappear like a mirage, in reality we are simply trading in a very
vibrant and living environment. If we do not understand the unseen influences of price, we can feel abused and
manipulated and at risk. However, the only real enemy to traders is ignorance.
Here is a representation commonly taught for the depreciation of time in an option. Looking at the last month
of trading, it is very common to illustrate it as follows.
Here the cost of time decay is a nice parabolic curve reaching zero at expiration day.
In reality, especially in volatile markets it is not uncommon to see dramatically different time movement over
the last four weeks.
 
This type of highly volatile movement is confusing and frustrating to traders if they are expecting time value
to follow the first image. For example, an approaching earnings date can hold time value very high and then drop
dramatically when the earnings are announced. This causes wild swings in the option price that are only
explained when you understand how the prices are calculated.
Sometimes, in calm markets, the cost of time will behave in a very benign way that also defies the basic model
in that time will decrease even faster than normal. This is because of such low expectations of volatile
movement.
It is said that ignorance is bliss, but I would suggest that ignorance is very expensive when it comes to
option trading. You cannot compete well against an opponent that you cannot see or that you do not know exists.
Volatility, as it affects time, will dramatically affect the price of the options that you trade.
The first lesson to be learned is that no one is deliberately manipulating options to hurt or benefit the
trader. The price of the options and their specific price action is a reflection of market conditions. This
means that the trader will get whatever they will get on an option and should not be frustrated if it does not
meet their expectations.
The second lesson is that understanding more about price movement of an option will adjust your expectations
going into the trade.
Third, options are never overpriced or underpriced. They are always priced to market conditions. This means that
they may be overpriced or underpriced to the model, but not to current market conditions. As the current
conditions dictate reality, the model adjusts by slowly changing and catching up. Remember, historical
volatility is a component to the model, so as history unfolds it is constantly adjusting the model. A trader
could compare this difference in movement to the difference between today's change in price to say, a 50 day
moving average.
Getting the maximum benefit of an option trade requires positioning the trade according to the conditions that
exist. These principles and the tricks to picking the right strike price, the right time frame, and even
deciding whether to buy or sell premium, are taught in great depth at the Advanced Traders Forge workshop.
-- Ryan
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