Hearing the word “Options” puts fear into the eyes of investors and traders…but it shouldn’t!

Some investors and traders believe that options are high-risk betting instruments… but that is not true!  

Much of the risk associated with options boils down to one of three reasons: a lack of education, experience, and understanding. 

Do you think that trading options can be less risky than trading stocks.

Well, it’s true, they can be far less risky than trading stocks.    

So, with understanding the basics of how options work, you will soon be able to reap the rewards of owning stock all while limiting risk!

But before you can begin slinging options for extraordinary returns… you must master the basics first. That’s what today’s lesson is all about.

 

Calls and Puts – Overview

 

You might have had success beating the markets by trading stocks using a strict process anticipating a move up or down. 

But unfortunately this success does not simply translate from stocks to options without fully understanding their unique characteristics.  

It’s important to understand how options work in order to trade them correctly and know where and when your position is open to risk.

Options contracts are priced using mathematical models such as the Black-Scholes and Binomial pricing models.

The primary drivers of the price of an option are:  

  • Current stock price
  • Intrinsic value
  • Time to expiration or the time value
  • Volatility (Historical)
  • Interest rates
  • Cash dividends paid

Let’s start with the primary drivers of price of an option: the current stock price, intrinsic value, time value, and volatility.

 

The current stock price

 

This is fairly straightforward, but the movement of the underlying stock price will impact the option pricing.  

If the stock price rises, it is likely the price of the call option will increase and the price of a put option will fall.

And if the stock price decreases, it is likely that the price of the call option will decrease and the price of a put option will increase.

 

Intrinsic Value

 

The intrinsic value is the value any option would have if it was exercised today.  This value is the amount by which the strike price of an option is in-the-money (ITM).  It is the portion of an option’s price that was not impacted by the passing of time.  

Note:  Options trading at-the-money (ATM) or out-of-the-money (OTM) have no intrinsic value

This equation is how to calculate intrinsic value:

Call Option Intrinsic Value = Underlying Stock Price – Call Strike Price

Put Option Intrinsic Value = Put Strike Price – Underlying Stock Price

For Example:

Let’s assume Apple (AAPL) stock is selling at $300.  The 295 call option would have an intrinsic value of $5.00 because the option holder can exercise his option to buy AAPL shares at $295 then turn around and sell them in the market for $300, or a profit of $5.00

 

Extrinsic Value

 

The Extrinsic Value (time value) of options is the amount by which the price of an option exceeds the intrinsic value.  

This value is directly related to how much time an option has before it expires including any projected implied volatility of the stock.

This equation how to calculate extrinsic value is:

Time Value = Options Price – Intrinsic Value

The more time an option has until it expires, the greater the chance it will end up in the money.  Time value is essentially the risk premium the option seller requires to provide the option buyer the right to buy/sell the stock at or before the date the option expires.    

For example,  If AAPL is trading at $300 and the 30 Days Till Expiration (DTE) call is trading at $6, the time value of the option is ($6 – $5) = $1.00

An options time value is also highly dependent on the volatility the markets expect the stock to have at expiration.  One measurement of volatility in stocks is by using the company’s beta. A “high beta” is said to be more volatile compared with “low beta” stocks.

 

Volatility

 

The effect of volatility is extremely difficult to measure and is highly impacted by a traders fear and greed. 

There are two types, implied volatility and historical volatility.  Implied volatility is the volatility in the options markets, where historical volatility is the volatility in the stock price.  

 

Historical Volatility

 

Historical volatility helps a trader to determine the possible magnitude of future moves of the underlying stock.  

Statistically, two-thirds or three-quarters of all recent price movement will happen plus or minus one standard deviation of the stock’s move over a set time period.  Historical volatility looks back in time to show how volatile the stock has been.  

This is extremely important for options traders to determine which price is most appropriate to select for their specific strategy.

 

Implied Volatility

 

Implied Volatility is what is implied by the current options prices and is generated from an options pricing model.  

This value helps set the current price of an existing option and helps players assess the potential of a trade.  

Implied volatility is a sentiment indicator as well and helps to give options traders what the current market expects future volatility to be. 

This future sentiment is reflected in the price of the option and has based on current option prices.

 

Conclusion

 

The bottom line is this…

Any options trader should really take the time to study the various options pricing models.  This is a must to understand how options are priced.

Besides the underlying price, the key factors of the option price are intrinsic value, volatility, and time value.  Knowing the current and expected volatility in the price of an option is critical for any investor who wants to take advantage of the movement of a stock.  

And this is all available without spending countless hours studying options.  Just click here to start following along as it’s been more than 6 months without a losing trade!

Author: Dave Lukas

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