I’ve often had traders come to me with questions about surprise behavior of an option’s price. The price changes seemed to defy the simple logic associated with an option’s delta (the measure of how sensitive an option’s price is to price changes of the underlying).
Most likely, I tell them, volatility is the culprit. A sudden drop in implied volatility (IV), one form of volatility, can undermine a trader’s strategy quickly. IV may suddenly drop, for example, instantly wiping out the hoped for gain even after a desired price move takes place – making expected gains appear like a profits mirage.
Nobody should lose money due to a misunderstanding of the anatomy of volatility. Learning how to tell if an option is expensive or cheap, for example, can help minimize any volatility risk.
Yet many traders rarely even consider the question of an option’s volatility-related valuation.It is important to assess an option’s price, among other important aspects of volatility.
-John Summa, PhD
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