Trading Options in Turbulent Markets: Master Uncertainty through Active Volatility Management

Chapter 11. Covering the Naked Put

Pricing an exchange-traded option requires the use of a complex mathematical formula. The mathematical model is driven by six basic factors:

1. Current price of the underlying

2. Strike price of the option

3. Time till expiry

4. Dividends

5. Interest rates

6. Volatility

Looking at the six components, you can know with near certainty what most of the inputs ought to be. You know, for example, exactly what the current price of the underlying is. The strike price of the option is an element of the option contract. You know specifically when the option contract is set to expire (exchange-traded options in general expire on the Saturday following the third Friday of the expiration month). You also have a high degree of certainty as to where interest rates are and what dividend, if any, will be paid on the underlying stock.

What an options price really boils down to is volatility, which is simply the model's evaluation of risk. In terms of the math, volatility is merely a measure of how much the underlying asset is expected to diverge from its current price. The input into the option pricing formula is the annual standard deviation of the stock's price.

Most option traders overlook volatility when making an investment decision. Traders will simply buy calls if they are bullish on the outlook of the underlying, or buy puts if they are bearish. The majority of options traders (probably) lose money over time, which speaks to the importance of understanding volatility. Many investors ...