Week of November 14, 2005

 Options Series Part 3

Market Movement & Volatility

Intrinsic value, that part of the option premium that represents real market value, increases as the futures market moves farther into the money. It is only market movement in the money that changes intrinsic value.

Time value is influenced by three factors. Of course the first and most obvious is the amount of time remaining until expiration. Another factor that affects time value is volatility. Volatility is the fear factor in option trading. When markets become dangerously wild the volatility can sometimes become as large a part of the time value equation as the time itself. That is because the option sellers realize that it has become much more difficult to estimate accurately the amount of risk in a fast moving market. Since they are responsible for paying off the winning option buyers, they know that they must collect more premium at the outset, “just in case.” The third force affecting time value is the distance between the market price and the strike price. The closer the market is to or the farther it is through the strike price, the more value an option has. The farther away from the strike the market is the less value it has.

Once you understand these basics it becomes much easier to recognize opportunities in the Option Market.

For instance, if I wanted to buy a Crude Oil call option but my spending limit is just $500, I would need to decide whether it might be better to buy a call close to the strike price with very little time until expiration or opt for one much farther away from the strike that would give me more time. There are also other possibilities available that involve option combinations but we will discuss those at a later time.