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Thread: Relationship between Option Price, Stock Price, and Volatility

  1. Default Relationship between Option Price, Stock Price, and Volatility

    I read that Option Price goes up when Implied Volatility goes up, and that Option Price goes down when Implied Volatility goes down. I also notice that Stock Price has an inverse relationship with Implied Volatility. When Stock Price goes up, IV goes down. When Stock Price goes down, IV goes up.

    This is really confusing to me. How does Call Option have any advantage here? Because if Stock Price goes up (Which is what I want when buying call option), IV goes down. I thought when IV goes down, Option Price goes down as well. Then how does Call Option ever make money? Put option makes sense to me, but not Call Option.

  2. Default

    The IV is priced into both Puts and they both have that disadvantage. But you are exactly right...that is what makes it tough to make money when you buy options...but guess who makes the money....the guy who sells them. So be the seller. Sell options when IV is near or above 50% and only buy them when it is low...and even then sell a cheaper option against it to reduce your cost basis.

    If you do not have the capital to sell naked options you can sell option spreads...which have defined risk...means your max loss is defined by the spread.

    And only play options that have a very tight bid/ask spread...until you understand mid price and open interest and how you will lose when you trade wide markets.

  3. Default

    Some things that we should clear up are:

    1. Option price in dependent on the IV.
    2. IV is how volatile people expect the stock to be. (its an estimate of the future volatility)
    3. The more volatile the stock, the higher the price of the call and put option. (Black scholes model)

    This means that when IV goes up, the price of the call/put option should also go up, when the IV goes down, the price of the call/put options should also go down. IV does not have anything to do with upward/downward movement of the stock, it only tells you how volatile the price of the stock is.( The higher the volatility, the higher the range of the price movement)

  4. Default

    The above is correct but to be more specific:
    1. Options price is a combination of intrinsic value and/or extrinsic value. Intrinsic value applies to in the money options, extrinsic value is a combination of time(theta) and volatility.
    2. IV is a value given to expected move of the underlying over a given amount of time at that moment.
    3. To be is the changes in options pricing that determines IV....IV does not generate prices. As more buyers of calls and puts buy to hedge risk the price goes up as demand increases....this change in price effects IV.
    4. And where IV is in relation to a given period of time, usually one year, gives you IV Rank And this is what is mean reverting and favors the seller.

    Here is one good video that explains it well

  5. Default

    I like to think of the implied volatility as "the excitement factor. You can calculate price of an option with a formula that takes into account things like stock price, days till expiration, strike price, etc. but the missing ingredient is how excited are the traders. You can imagine that an AAPL option the day before earnings will be priced higher than it might be 2 weeks later because everyone is excited to see ho the new iPhone sold in the last quarter. Once the new is out thee excitement i diminished with the implied volatility.

    If the stock starts to plummet, people will get excited to profit, protect their portfolio, o joint the ride. IV goes up. If the stock is flat with no news in week, IV will sink, and the relative price of the options will fall a bit.

    Don't confuse the "real" volatility (movement) of the stock price with IV. They are only loosely related.

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