Introduction

Options trading might provide a way to achieve good returns in the stock market, though it carries significant risks. It also offers leverage, which allows you to invest without significant capital. However, it is also risky and needs careful consideration to get the desired results. To trade with caution, you must consider the crucial factors influencing option prices. Several variables affect the option prices, including the underlying asset's price, time to expiration, type of option (call or put), risk-free interest rate, etc.

Besides these factors, volatility is critical in determining an option's price. As investors' sentiments collectively change based on market volatility, the option demand fluctuates, and so do the prices. Hence, understanding options volatility is critical to devising appropriate pricing strategies and trading confidently.

What is option volatility?

Option volatility represents the price variation of an option over time. Volatility does not have a fixed value. It essentially shows you the risk associated with an option. The calculation of volatility happens in terms of percentage annually.

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Volatility is broadly classified as historical and implied. Historical volatility indicates the underlying price movements of an option over time, e.g., over the past year or month. Historical volatility (HV) is typically higher when the options are risky. Conversely, Implied volatility (IV) indicates the level of underlying volatility based on the current option price. Since IV forecasts future price changes, it is considered more relevant to options trading.

Factors influencing option volatility

Option volatility, whether historical or implied, occurs due to a range of factors. They include:

• Economic indicators: Financial indicators in the economy, like nationwide data, earning reports, and more, affect the volatility of options of an index or stock.

• Market forces: Option prices fluctuate when there is volatility due to political unrest or economic instability.

• Demand and supply: Higher demand for an option increases its volatility. On the other hand, increased supply reduces the volatility.

Best options trading pricing strategies

When you buy or sell an asset at a predetermined price at a specific timeframe, you engage in a call or put option, respectively. With option trading, you establish a contract. But it's not an obligation, which allows you to decide terms of exercising your rights based on the market volatility. Hence, you can consider option volatility and pricing strategy to make an informed decision.

Some prominent pricing strategies to trade around IV are:

• Naked call & put:

Naked call or put options are considered a simple strategy. They are easy to execute. However, the simpler their execution, the riskier they are. You need trading experience to use this strategy optimally. Poor implementation may cause limitless losses.

In this strategy, you can sell an out-of-money option when you see a bullish trend in the market. Meaning, that the market sentiment is bullish or neutral, and you can benefit from high volatility. Likewise, if you suspect the market will remain bearish, you can draw a naked call. You can then sell the out-of-money call option and make returns when the underlying price drops.

• Short strangle & straddle

The short strangle & straddle pricing strategy focuses on the strike price, a predetermined price at which you execute an option contract. Through a short straddle, you opt for call and put options at an alike strike price. This way, you can keep the premium from both options. It's worth implementing this strategy when you expect the IV to fall near expiration.

A short strangle works like a short straddle, except the strike price of call and put options are do not mimic in strangle. The call option's strike price is consistently higher than the put option.

• Iron condors

If you like the idea behind a short strangle but want to minimise the risk, consider Iron condors. It involves trading to improve profit potential while reducing the risk volume. You can trade a pair of out-of-money call and put option spreads while balancing your long and short positions on one call and one put option.

• Ratio writing

In simple terms, you apply a ratio to options in ratio writing. Let's take a ratio of 2:1, for example. Here, you sell two options for every option bought. This way, you can benefit from any decrease in the IV before an option expires.

Conclusion

Options trading presents an excellent opportunity to make the most of your investments. However, navigating the stock market carefully. Plus, understanding concepts like volatility, among other factors determining the option's price, helps. This way, you can leverage the pricing strategies discussed above. Implement these strategies based on your trading objectives and risk appetite for the best results.

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