Chapter 1. Clues from the Options Market

 

Successful investing is anticipating the anticipations of others.

 
 --—JOHN MAYNARD KEYNES

It can be tough enough to do well in the stock market. The options market, with its additional layers of complexity, might appear to be an even more challenging place to gain an advantage. Some of the smartest, quickest pros operate in the options market where, like traditional chess grand masters, they are slowly being outsmarted by computer algorithms. But there's no need to battle the options pros or the computers to glean useful information from the options market.

The Basics

At its most basic, an option is simple. It's the right to buy (call) or sell (put) a stock at a stated price (strike) until a certain point in time (expiration date). It's not hard to understand, but it is hard to correctly value.

Though the mathematical specifics are beyond the scope of this book, traders use a few pieces of information to calculate an option's price. These include the risk-free cost of money (due to the underlying loan that's typically present), the stock price, the option's strike price, and the amount of time left on the option. These are all known numbers. An unknown variable, called implied volatility, ties these known numbers together.

An option's implied volatility measures how much the market thinks a stock's value will change—in either direction—in the future. A boring company often has an established business base that probably won't change much. An electric ...

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