- The right, but not the obligation, to buy a specific number of shares of the underlying security at a defined price, until the expiration date.
- The right, but not the obligation, to sell a specific number of shares of the underlying security at a defined price until the expiration date.
- Strike price
- The price at which option holders can exercise their rights.
- The process in which the buyer of an option takes, or makes, delivery of the underlying contract.
- The process by which the seller of an option is notified that the contract has been exercised.
- The time at which an option can no longer be exercised.
- In the Money (ITM)
- A call (put) option whose strike price is below (above) the stock price.
- At the Money (ATM)
- An option whose strike price is roughly equal to the stock price.
- Out of the Money (OTM)
- A call (put) option whose strike price is above (below) the stock price.
- American style
- An option that can be exercised at any time before expiration
- European style
- An option that can be exercised only at expiration. (Note: These are mainly index securities.)
- Intrinsic value
- The amount that an option is in the money.
- Time value
- The price of an option less the intrinsic value.
For any given option contract, we need to know the most recent prices and other factors. Option chains show data for a given underlying’s different strike prices and expiration months.
Each strike lists:
- The price of the last trade (“Last”)
- The price at which there are willing buyers (the “Bid”)
- The price at which a contract is offered for sale (the “Ask” or “Offer”)
- The volume of the day’s trading (“Vol”)
- The contract’s “open interest” (“Open Int”), which tells us how many active contracts there are for a given month and strike.
Time value is subject to several factors, primarily time to expiration and implied volatility. Implied volatility is the market’s expectation of the future volatility of the underlying stock. It is derived from the option price itself, and represents demand for the option. The higher the implied volatility, the more expectation that the underlying stock will make big moves, increasing the option’s chances of being in the money. This also means that the option’s premiums (that is, its time value) are higher. However, the value of time decays as expiration nears: time decay increases dramatically in the last 30 days as expiration approaches.
Let’s consider an example using Google (GOOG). If GOOG were trading at $900 when you bought a 890 strike call option for $25, then $10 of the option’s value would be intrinsic value.
The other $15 would be time value. A 900 call purchased when GOOG is trading for 900 is at the money, but is all time value. It has no intrinsic value.
If the stock were at 900 when you bought a 910 call, the option is again all time value, since it has to rise $10 to be in the money.
Options Pricing was revolutionized in 1973 with the publication of the Black-Scholes Model, the Nobel-prize winning equation which virtually created the options marketplace.
While looking at this formula completely written out would be, for most people, absolutely confounding, a comprehension of options pricing is well within the realm of understanding of anyone with simple math skills and knowledge of their auto insurance policy.
Let’s analyze the different components which are used to determine the theoretical value of an option:
That Stock Price, Strike Price, Time to Expiration, Interest Rates and Dividends
(combined to make the Cost of Money) and Volatility are the
inputs to pricing options, and that all are conceivably known except Volatility
|Another concept you must be aware of is the designation of options as In-the-Money, At-the-Money and Out-of-the-Money.|
|An In-the-Money option has a strike price which, for Calls, is below the present market price and, for Puts, is above the current market price.|
|An Out-of-the-Money option has a strike which, for Calls, is above the present market price and, for Puts, is below the current market price.|
|An At-the-Money option has a strike whether Call or Put which is equal to or near equal to the present price of the underlying.|
The distinctions of whether an option is In-, At- or Out-of-the-Money are also
important because they help to illustrate the concepts of Intrinsic Value and Time
Now, only In-the-Money options have Intrinsic Value. A 50 Call on a $55 stock is intrinsically worth at least $5, since you could exercise the option right away, buy the stock at $50 and sell it at $55, earning $5.
However, options will almost always trade at more than that. This is because all options, whether In-, At- or Out-of-the-Money have Time Value. Time Value is the extra premium the option has because of the possibility for additional price movements in the underlying security.
|Let’s break this down with real numbers.|
|If the 50 Call premium is 6, and the stock is trading at $55, the Intrinsic or In-the-Money amount is $5. The remainder, or $1, is the Time Value. Thus, this option is valued at 6 even though, intrinsically, it is only worth 5 right now. The additional 1 exists because of the stock’s volatility (i.e., the possibility that it may move more than where it is right now).|
|The 55 Call, however, is trading for 3, or the 60 Call is trading for 1. With the stock trading at $55, neither of these options have any Intrinsic Value, but they have Time Value because of the possibility that the stock may move that way.|
|Options cannot have negative values, and neither Intrinsic Value nor Time Value can ever be negative.|
The general concept of how options prices are related to each other is known as Put/Call Parity. The basic concept is that stock prices, Call prices, and Put prices must have a certain relationship with each other or else professional traders would be able to make nearly risk-free trades.
Option traders, both professional and non-professional, use the concept of Put/Call parity to help them understand different option price behaviors and, therefore, make trading decisions
Time affects options prices. In fact, if the price of a stock remains the same, options decrease in value the closer they get to the expiration date. This concept is known as Time Decay.
As an option owner or writer, you want to consider time decay when trading options so you understand which options best fit your strategy outlook. Look at the graph to see how the option value decreases from 90 days to expiration.
NOTE: In the last 30 days before expiration, time decay increases exponentially.
If you trade stocks, you are already familiar with Volatility. In the stock trader’s world, it is known as risk. The larger the price fluctuations, the riskier the stock, and the more expensive the options for that stock.
With stocks, price fluctuations are measured by the direction of the price and the size of the price change. With options, we are only concerned with the size of the price change, not the direction. Volatility is a percentage which reflects the average or expected size of the price change without regard to the direction of the change.
Volatilities of different options can be compared just like stock traders compare the price/earnings ratios (p/e) of different stocks.
When an option price has a low volatility, a big move is considered unlikely.
And when an option price has a high volatility, a big move is considered more likely.
Vertical involves two options of the same type, with the same expiration, but with different strike prices.
One of the options is purchased (or long), and the other is sold (or short).
Two common types of vertical spreads are the Bull Call Spread and the Bear Put Spread
|Buy one call and sell another call with a higher strike price and having the same underlying stock and same expiration date.|
|Forecast: The market indicates a moderate stock price rise (a rise to, or slightly above, the upper strike price|
|Max Risk: 4 (the net premium paid)|
|Max Gain: 10 – 4 = 6|
|Break-even (at expiration): 100 + 4 = 104|
|Loss if stock is unchanged = 1.50 [-4 (cost of spread) +2.50 (value of spread @ 102.5) = -1.50]|
Bull call spreads have limited profit potential and limited risk. They may be the strategy of choice when the market forecast indicates a moderate stock price rise (a rise to, or slightly above, the upper strike price).
“I think the stock price will rise from $102.50 to $110.”
|Buy one put and sell another put with the same underlying stock and same expiration date but with a lower strike price.|
|Forecast: The market indicates a moderate stock price decline (a decline to, or slightly below, the lower strike price).|
|Max Risk: 2.25 (the net premium paid)|
|Max Gain: 5 – 2.25 = 2.75|
|Break-even (at expiration): 65 – 2.25 = 62.75|
|Loss if stock is unchanged = 1.00 (cost of spread – value of spread @ 63.75 = 2.25 – 1.25)|
Bear put spreads have limited profit potential and limited risk. They may be the
strategy of choice when the market forecast indicates a moderate stock price decline (a decline to, or
slightly below, the lower strike price).
|Stock Price = $900||Strike Price|
|890 call = $25||900 call = $18||910 call = $10|
|$10 Intrinsic||$0 Intrinsic||$0 Intrinsic|
|$15 time value||$18 time value||$10 time|
|Intrinsic Value = Stock Price – Strike Price||Intrinsic Value = Strike Price – Stock Price|
|Time Value = Option Price – Intrinsic Value||Time Value = Option Price – Intrinsic Value|