Identifying Profitable Option Positions

Option traders initiate option positions based on either an anticipated price change of the underlying asset, the difference between the current implied volatility of the option and the expected future volatility of the asset, or an anticipated change in both price and volatility. For example, for a trade based on price change, an option would be purchased or sold based upon analysis that there is good reason to believe that the asset will rise or fall in price. An option trade based on volatility would be where the option trader sells (shorts) a call or put because they believe that the implied volatility of the option will decrease to a level much lower than it is currently. Finally, a trade could be taken based on a market analysis that predicts both price and volatility of the underlying asset to increase.

Before placing an options trade, a trader should ascertain whether or not the option is priced at a value that will permit a profitable trade if their market assumptions are correct. Too often, option traders find they were correct about asset direction and/or volatility, but still lose money because the option position that was purchased was too expensive or was sold at a price that was too low.

Important factors in identifying a profitable option position include understanding fair value, theoretical value, and theoretical profit and loss. Understanding these concepts and how to use them in option trading can help you to avoid purchasing option positions that are too expensive and selling positions too cheaply.

For more information, see Fair Value and Theoretical Value and Theoretical Profit and Loss.