Three ways to win with options

There are three major factors that affect the profitably of an options trade. Options prices are influenced by the price of the underlying asset, the volatility of that asset, and the passage of time.

The first factor affecting options pricing is the price of the underlying asset. If you are long a call or short a put and the price of the underlying goes up you make money. If it goes down your long calls or short puts loose money. The inverse is true for a long put or short call.

The next factor that affects pricing of options is the volatility of the underlying. There are two types of volatility, Statistical and Implied. Statistical volatility (SV) or Historical volatility (HV) is the measure of how much the underlying asset moves. Implied volatility (IV) is how much the market expects the underlying to move. Volatility is mean reverting and tends to move back towards its average. When volatility is trading at extreme high or low levels there is a good chance that it will move back towards its historical average. When IV is greater than SV and IV is trading in the upper end of its range options are expensive. When IV is lower than SV and IV is trading in the lower end of its range options are cheap. When volatility moves higher options increase in value and when volatility drops options decrease in value. You should use options premium selling strategies when options are expensive and premium buying strategies when options are cheap.

Example of a Volatility Chart for SPY from IVolatility.com

The third factor affecting the value of options is time. This is the only constant factor you can count on when trading besides commissions and taxes. Options lose money everyday due to time decay. This can be good for the seller but bad for the buyer.

When trading you need all the edge you can get. Structuring you options trades to profit from price, volatility and time can help stack the odds in your favor.