Options can be used in a wide variety of strategies, from conservative to high risk. They can also be tailored to meet expectations that go beyondsimple directional strategies. So, once you learnbasicoptions terminology, it makes sense to investigatefactors that affect an option's price in various scenarios.
Key Takeaways
- Options are derivative contracts the right, but not the obligation, to buy (for a call option) or sell (for a put option) some asset at a pre-determined price on or before the contract expires.
- Options can be used for directional strategies or to hedge against certain risks in the market.
- Pricing an option relies on complex mathematical formulas, but the direct inputs into an option's price include the price of the underlying asset, the option's strike, time to expiration, interest rates, and implied volatility.
Using Options ForDirectional Strategies
When stock traders first begin using options, it is usually to purchase a call or a put for directional trading, in which they expectastockwill move in a particular direction. These traders may choose anoptionrather than the underlying stock due to limited risk, high reward potential,and lesscapital required to control the same number of shares.
If theoutlook is positive (bullish), buying a call option creates the opportunity to share in the upside potentialwithout having to risk more than a fraction of themarket value. If bearish, buying a put lets the tradertake advantage of a fall without the marginrequiredto sellshort.
Market Direction And Value
Many kinds of option strategies can be constructedbut the position's success or failuredependson athorough understanding of the two types of options: the put and the call. Furthermore, taking full advantage of options requires a new way of thinking becausetraders whothink solely in terms of market direction miss all sorts of opportunities.
In addition tomoving up or down, stocks can move sideways or trend modestly higher or lower for long periods of time. They can also make substantial moves up or down in price, then reverse direction and windup back where they started. These kinds of price movements cause headaches for stock traders but give option traders theexclusive opportunity to make money even if the stock goes nowhere. Calendar spreads, straddles, strangles and butterflieshighlighta few optionstrategies designed to profit in those types of situations.
Basics of Option Pricing
Options traders need to understandadditional variables that affect an option's price and the complexity of choosing the right strategy. Once a stock trader becomes good at predicting future price movement.They may believeit is an easy transition from options but this isn't true. Options traders must deal with three shifting parameters that affect the price: the price of the underlying security, time, and volatility. Changes in any or all of these variablesaffect the option's value.
Option pricing theory uses variables (stock price, exercise price, volatility, interest rate, time to expiration) to theoretically value an option. Essentially, it provides an estimation of an option'sfair valuewhich traders incorporate into their strategies to maximize profits. Some commonly used models to value options areBlack-Scholes,binomial option pricing, andMonte-Carlo simulation. These theories have wide margins for error due to derivingtheir values from other assets, usually the price of a company'scommon stock. There are mathematical formulasdesigned to compute the fair value of an option. The tradersimply inputs knownvariablesand gets an answer thatdescribeswhat theoption should be worth.
The primary goal of any option pricing model is to calculate the probability that an option will be exercised, or bein-the-money(ITM), at expiration. Underlying asset price (stock price),exercise price,volatility,interest rate, and time to expiration, which is the number of days between the calculation date and the option's exercise date, are commonly used variables that are input into mathematical models to derive an option's theoretical fair value.
Key Pricing Inputs
Here are the general effects thatvariables have on an option's price:
1. Underlying Price& Strike Price
The value of calls and puts are affected by changes in the underlying stock price in a relatively straightforward manner. When the stock price goes up, calls should gain in value because you are able to buy the underlying asset at a lower price than where the market is, and puts should decrease. Likewise, put options should increase in value and calls should drop as the stock price falls, as the put holder gives the right to sell stock at prices above the falling market price.
That pre-determined price at which to buy or sell is called the option's strike price or exercise price. If the strike price allows you to buy or sell the underlying at a level which allows for an immediate profit buy disposing of that transaction in the open market, the option is in-the-money (for example a call to buy shares at $10 when the market price is currently $15, you can make an immediate $5 profit).
2. Time to Expiration
The effect of time iseasy to conceptualize buttakes experience before understanding its impact due to the expiration date.Time works in the stock trader's favorbecause goodcompanies tend to rise over long periods of time. But time is the enemy of the buyer of the option because,if days pass without asignificant change in the price of the underlying, the value of the option will decline. In addition, the value of an option will declinemore rapidly as itapproaches the expiration date. Conversely, that is good news for the option seller, who tries to benefit from time decay, especially during thefinal month when it occurs most rapidly.
3. Interest Rates
Like most other financial assets, options prices are influenced by prevailing interest rates, and are impacted by interest rate changes. Call option and put option premiums are impacted inversely as interest rates change: calls benefit from rising rates while puts lose value. The opposite is true when interest rates fall.
4. Volatility
The effect of volatility on an option's price is the hardest concept for beginners to understand. It relieson a measure called statistical (sometimes called historical) volatility, or SV for short, lookingatpast price movements of the stockover a given period of time.
Option pricing models require the trader to enter future volatilityduring the life of the option. Naturally, option traders don't really know what itwill be andhave toguess by working the pricing model "backwards". After all, the traderalready knows the price at which the option is trading and canexamineother variablesincludinginterest rates, dividends, and time leftwith a bit of research. As a result,the only missing number will befuture volatility, which can beestimatedfrom other inputs
These inputs form the core ofimplied volatility, a key measure used by option traders. It is called implied volatility (IV) because it allows traders to determine what they think future volatility is likely to be.
Traders use IV to gauge if options are cheap or expensive. You may hear option traders say that premium levels are high or that premium levels are low. What they really mean is that the current IV is high or low. Once understood, the tradercan determine when it is a good time to buy options - becausepremiums are cheap - and when it is a good time to sell options - becausethey are expensive.
The Bottom Line
Options are complex, but their price can be described by just a handful of variables, most of which are known in advance. Only the volatility of the underlying asset remains a matter of estimation. Once you have a firm grasp of the essentials, you'll find that options provideflexibility to tailor the risk and reward of every trade to your individual strategies.
