When you want to trade options, it could be overwhelming. If you ask people whether you should trade options, they’ll probably say something like, “Stick to stocks.” Well, what if I told you could learn to trade options easily. Heck, you don’t even need to know all the heavy math behind options. All you need to know are some key factors and understand how options move.
- refers to the amount per share that the option is trading at;
- is a two-factor value comprised of the intrinsic value and extrinsic value; and
- may be determined using different kinds of mathematical models.
For the most part, we’re focused on directional options trades. That means we’re either buying calls or puts. Keeping things simple when you’re learning to trade options helps a great deal. Moreover, what if I told you that it’s possible to multiply your money with this simple options strategy. All you need to do is first learn about options and a bit of technical analysis, coupled with catalyst events. In this article, we’ll tell you everything you need to know about how options are priced so you’re ready to start making money on options trading.
Trade Options: How Options Are Priced
If you don’t already know, options have been around for a while now. However, they’ve only become popularized over the last 40 to 50 years. Generally, when you learn to trade options at school, you would need a lot of math and a bit of physics to understand the theory behind options pricing. However, don’t be scared. We’re going to focus on the basics here and look at the factors affecting an option’s value. We’ve kept it simple and only focus on the factors that really affect option prices.
There are three major factors affecting stock option prices that are factored in to how options are priced:
- The underlying stock’s price
- Time to expiration date
The “less” important factors affecting options prices:
- Short-term interest rates
Keep in mind that interest rates would matter if they’re constantly changing. That said, let’s take a look at how these factors affect an option’s price.
Underlying Stock’s Price
For call options, when the underlying stock’s price rises, the option’s price should increase. The opposite is true when the stock drops. On the other hand, as the underlying price rises, put option premiums fall. When the underlying stock’s price rises, put option premiums would rise. Pretty simple right?
When you directionally trade options, the underlying stock price is extremely important.
For example, here’s a look at Tesla (TSLA) put options.
It’s quite clear, when looking at this profit and loss diagram, you want the underlying stock price to fall.
The opposite is true if you bought call options.
Time Value and Expiration in Options Pricing
When there is a lot of time remaining until the option’s expiration date, the premium would be higher. In other words, an option with one year until its expiration date would have a higher premium than one with one month until expiration, all else being equal.
For example, if you look at the put options for TslA, they cost a lot less than these, which have a lot more time to expiration.
Volatility is the underlying stock’s tendency to fluctuate in price. This means volatility reflects the price change’s magnitude and does not have a bias toward price movement in one direction or another. You need to understand that the higher the volatility, the higher the option premium should be. The lower the volatility, the lower the premium.
You might notice that some options are more expensive than others, even if they’re at the money. This is due to the fact that some stocks tend to be more volatile than others.
Generally, interest rates do not affect premiums as much as the time value, the underlying stock price, and volatility. However, when interest rates experience a high degree of fluctuations, rates matter. An increase in interest rates typically increases call prices and decreases put prices, based on the famous Black-Scholes pricing model. There are flaws with this model, but it’s an industry standard. However, we won’t get into all the details of this pricing model.
Options are often priced assuming they would only be exercised on the expiration date. That means if a stock issues a dividend, the call options could be discounted by as much as the dividend amount. However, put options would be more expensive since the stock price should drop by the dividend amount after the ex-dividend date.
Understanding How Options Are Priced is Crucial
If you want to trade options, it helps to understand how options are priced. For the most part, I like to buy at-the-money options. That means if a stock is trading at $50, I’ll try to buy options with a strike price close to $50. I found that this is highly lucrative when I use my simple strategy. Basically, I wait for the charts to tell me whether I should be buying put options or call options. Thereafter, I just have to execute.
If you’re ready to learn more about options trading, check out RagingBull’s e-book, available for free for a limited time. You’ll learn more about how options are priced, as well as trading strategies that will help you to up your profits.
Once you figure out how options are priced and learn how to use the money pattern, it’s not crazy to see profits like this.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.