Over the past year, the world we live in has drastically changed. In the Covid era, we have lived in the midst of a pandemic requiring limited personal interactions with people outside our households and seemingly endless precautions in an effort to slow the spread. In short, the world we live in today is radically different than the way things were less than two years ago. Since we have all be locked away in our homes, working remotely or not working at all, we have had to take on learning new skills. One skill everyone has been flocking to is trading.
According to a recent Charles Swab survey, fifteen percent of current retail investors began investing in 2020. This is a big number. Many of those investors cling to stock options as a way to leverage small money and trade big. With all the new traders trading, the markets have changed along with everything else. Many refer to these new traders as the “dumb” money while the historical institutional investors as the “smart” money.
Many of these new traders trade options before having any idea of how the price of an option is really constructed. They believe they can buy the option and only time and the price of the underlying stock matters in the price movement of the option. This is not the case. So, what are they missing?
The number one most overlooked factor in options pricing that most traders ignore is………drum roll……..Volatility! Yes, that’s right I said volatility. Volatility arguably could be the most important factor in option pricing. But before I explain, we must first understand what is meant by Volatility in options pricing. With volatility, you have two types – historical volatility and implied volatility. Historical volatility is what price volatility was historically, while implied is what the future volatility is expected to be. To sum in simple terms: The higher the volatility of the underlying asset, the higher the price is for both call and put options. This happens because higher volatility increases the price range of the underlying asset.
The most overlooked factor that most traders ignore…Volatility
So back to the most overlooked factor that most traders ignore – why volatility? In options trading, volatility will move up and down as the price of the underlying asset range increases. This can make a trade, where you have direction and time right, a losing trade and make a trade, where you miss the direction and time, yet still make a profit. That is the power of volatility that most traders, especially new ones, overlook. In many cases this can lead to catastrophic losses in trading options. In many cases, the script goes like this:
- The euphoria of trading options sets in as new traders just walk up and trade options.
- They will start with one lot and go small and may get a few wins.
- They then start to increase their size as they have been winning.
- Then the market teaches them a lesson and they lose (because their size was larger overall, they are at a net loss).
So, if one trades options, why should they care about volatility? One should care because arguably, this can affect options pricing the most and can turn winning trades into losing ones.