While there are many factors that determine option prices, stock option premiums move in unison with the underlying stock price. The most popular method for determining option value is the Black-Scholes Model. There are six factors in this model:
- Stock price is the most important factor in an options price as changes in stock price affect the price of options on the stock;
- Strike price has an affect on option price through intrinsic value, time value, delta and other factors;
- Time to expiration is the time remaining before an option expires. Due to time decay, option values can decrease at a faster rate when the option is closer to expiration;
- Stock volatility is the standard deviation of a stocks price variations over a fixed period of time. The more volatile the stock, the more likely its price will move and the option price will increase with high volatility;
- Interest rates have little affect on option prices but they are part of the Black-Scholes model;
- Stock dividends also have little affect on option prices since they are already included in the stocks price by market forces.
There are other forces that can affect the price of options that are not included in the Black-Sholes model such as:
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- Supply and demand for the stock
- Liquidity or volume of the option
- Markets expectation of future events such as earnings, etc.
- Markets expectation of future price direction of the stock
I have created an investment that achieves higher monthly returns while managing stock risks in the trade. You may be skeptical of this concept and should be when you hear something like this introduced into your trading plan. To explain, let’s look at what must happen to a stock price for a successful PUT selling trade. To keep the premium from the PUT sell, the stock price must be above the PUT option strike price at expiration. To increase my percent of winning PUT trades, I invest in stocks with price momentum moving higher. This increases the probability of the stock price closing above the strike price – giving us more winning trades.
How do I identify these winning trades? I combine the fundamentals of a stock with its price performance on its stock chart. I find securities that have a positive change in price that creates upward price momentum. You may have heard about price breakouts and other upward biased chart patterns. This introduces a concept of technical analysis into our trading plan.
Technical analysis uses stock price movements and trading activity as the basis for drawing a conclusion about where the price may be headed. It is based on the premise that prices move in trends that tend to continue until something changes to affect the balance of supply and demand for the stock. These changes can be detected by analyzing prior changes, looking for recurring patterns that indicate a price trend, or indicate areas of support and resistance that may influence the price direction.
We continue to identify winning option trades to generate income and to exit early as the stock bullish patterns moves prices higher.
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