To understand how, we need to take a step back for a second and look at exactly what an option is and what its price represents.

An option is a contract that gives an investor the right to buy or sell a stock at a certain price (called a “strike price”) by a certain date. These investments give traders a lot of flexibility that stock investors don’t have. Most investors who buy stocks can only make money if share prices climb. Options investors can make money if the stock moves in either direction by investing in the right kind of option.

Traders buy “call” options when they think the underlying stock is going to rise in price. If you think Exxon Mobil’s (XOM:NYSE) share price is going to climb from $80 to $85, you might want to buy call options. Call options increase in value when a stock’s share price climbs.

Traders buy “put” options when they think the underlying stock is going to fall in price. If you think Exxon Mobil’s share price is going to fall from $80 to $75, you might want to buy put options. Put options increase in value when a stock’s share price falls.

This last bit is how options traders make money when the market is falling.

Now that we have a basic understanding of what options are, let’s talk about how options are priced.

The Five Components That Influence an Option’s Price

Stock Price — Obviously the price of the underlying asset (stock, index, ETF, etc.) will have an effect on the price of an option.

Time Till Expiration – All options have an expiration date. The longer an option has until its expiration, the more expensive it is. You’re basically paying for more time for the underlying stock to move. The amount of time until an option expires will have a direct effect on the price.

Dividends – Believe it or not, dividends also influence option value. Dividends lower the price of calls and raise the price of puts. (When you buy an option, all the dividend math is already figured in.)

Interest — Interest rates have a fairly minor effect on most options, but they do influence option prices. Higher interest rates will increase call values and lower put values.

Volatility — If there is a high demand for an option or if a stock is extremely erratic, “implied” volatility will be higher and the option more expensive and vice versa. Here’s what that means:

• The implied volatility is related to events and movements in the stock. It is always expressed in percentage terms.
• If an option’s volatility is out of line or looks abnormal, it could spell trouble on the horizon.
• It can also tell us things that the stock charts or news can’t…

When the Natural Order Is Disturbed

The fact is that most of the investment community and media know little or nothing about options. They say the Volatility Index (VIX) is telling us whether the market is overbought or oversold or if investors are scared or confident. The truth is that the VIX alone can’t even come close to predicting these things without considering other factors.

There is an innate balance and relationship between a stock and its options as well as the puts and calls themselves.

What I am about to show you is what we professionals use to spot impending danger or safe opportunities. When there is a severe disparity between different options volatility, professional traders can use it to their advantage.

One of the simplest uses is to gauge real market sentiment.

(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the stock market for you with our easy-to-understand investment articles.)

Meet “SKEW”

Without turning this into a math lesson or boring you all to death, I’ll keep this simple and straight forward.

Look at the chart below. This is an options chain, or a list of all the different options you can buy on a specific stock or ETF. This options chain is for the S&P 500 Index.

You will see two options highlighted. One is a put (highlighted in red) and the other is a Read more