One important difference between options and stocks is that options are really contracts.  They always have two sides, so for every call or put purchased there is someone else selling it.  Options are a zero-sum game.  That means the option buyer's gain is the option seller's loss, and vice versa.  Because of this, any payoff diagram for an option purchase must be the mirror image of the seller's profit and loss profile.

Understanding the terminology and rules for options is necessary before you start trading them.  Beyond that, you need to develop a thorough understanding of risk and how it varies from one strategy to another.  Remember that options can be used in a wide variety of strategies, from conservative to very high-risk.  Many traders are first attracted to options for high-leverage directional trading.  Directional trading is when a trader believes he knows which way a stock price will move and opens an option position to take advantage of it.

With stock you only have to worry about one thing – price.  In the landscape of options you have three shifting parameters: the price of the underlying stock, daily time decay, and volatility.  Changes in any one of these will affect the value of your options.  How the value of calls and puts are affected by changes in the underlying stock price is relatively straightforward.  Time is another concept that is fairly easy to understand.  The fact that options will expire and may become worthless in the future is an important and key feature in every option strategy; ultimately, it can determine whether your option trading decisions are profitable or not.

The effect volatility has on an options value is usually harder for beginners to understand, and we have several articles posted that try to clearly explain how to take volatility into account you’re your trading.  Ideally, what traders would like to know is what future volatility will be.  But since we don't know that, we try to guess what it will be. 

The beginning point for this guess is statistical (sometimes called historical) volatility, or SV.  The SV tells us what the actual volatility has been for this stock over a given period of time.  However there is another measure of volatility called implied volatility, or IV, which traders use to decide if options are cheap or expensive.  The charts included in the MarketVue tools allow you to see the current volatility situation for any asset at a glance.

There are different models for pricing options, but most will yield a price relatively close to each other.  When you put in all the variables (stock price, time, interest rates, dividends, and volatility), you get an answer that tells you, based on those numbers, what an option should be worth.  But what if you work the model backwards?  After all, you know what the option is trading at.  You can also find out the other variables (stock price, interest rates, dividends, and time left in the option) with a bit of research.  In fact, the only thing you don’t know for sure is what future volatility will be.

When you put all those numbers in and work the pricing model backwards you get implied volatility, so named because it is the volatility implied by the actual option price.  So IV is calculated based on the currently traded option premiums.  Option traders often say that "Premium levels are high" or "Premium levels are low".  What they really mean is that current IV is high or low.  Once you understand this concept, then it makes sense that you should try to buy options when their premiums are cheap, and sell options when they are expensive.

Your approach to trading options should always be based on the level of risk you think is appropriate.  Most investors use options as part of a larger strategy based on selection of stocks.  At OptionVue Research we teach that fundamental analysis and technical indicators are the logical starting point, and we have a lot of educational content designed to explain the methodology behind these. 

Our goal is to help you become a successful option trader.  The method we use to reach this goal is to demonstrate with our trade recommendations and educational articles how you can increase your investing profits without exposing yourself to unacceptable risks.