I came across a interesting article a while ago I thought I would share with you. This is an extremely important topic to an option buyer, and this will be some of the content that will be discussed in my new Monday class going forward. Take a look...

http://biz.yahoo.com/opt/060717/9755a0caaaafd655661d7d81dc2928d5.html

Have you ever bought an option, had the price move favorably, but still managed to lose money? If you have then you need to learn more about how options are priced, and the different factors that go into the pricing of an option. I think most people are so concerned with Delta to measure how much their option can make, they forget to realize how much that option can lose if the price of the stock goes down. Most people know I trade a very low delta in my option selection, but also trade a high vega. Normally this is achieved with an out-the-money option. This is an aggressive selection based on probabilities. The further out-the-money you get, the lower the probability is of a profitable outcome.

Let's digress to define the two greeks. An option Delta represents the rate of change in the option premium based on the change of price in the underlying asset. Option Vega represents the sensitivity of the option price to a change in option volatility. Once you get a better understanding of option vega you can actually profit on an option without having a price move in your favor.

I like to use the example of GOOG. Back at the mid/end of June I picked up some Sept 450 calls for $8.20. The reason for this trade was not exactly the triangle formation. I knew there was about 3 weeks until Google announced earnings. Volatility will typically rise up until an earnings announcement. As volatility rose, I watched the price of the option more than double...however I didn't anticipate the price of Google dropping a whole lot, and it did drop about $15 overall before the announcement. Try to picture an out-the-money option and what will happen to it's value with a price drop like that. Don't forget my option lost about three weeks value while I held onto it. My $450 calls that lost 3 weeks of time, and about $15 dollars from the stock price actually made me money! Not a lot...but I sold before earnings for $8.60. This might not seem like a huge profit, but without a solid vega and rising volatility, my option would not have sustained those set-backs. I was anticipating a much larger rise in volatility, but even a minor rise still created a profitable trade.

Fascinating isn't it?

Posted by Option Addict on 8/17/2006 at 7:31 PM | Permalink