Options Pricing and Value
You do need to learn and become familiar with the concept of stock option valuation to understand how the value and price of options are derived. You do not need to know the detailed models such as Black-Scholes etc., but if you understand the underlying concepts, then you will hold an important key to profitable option trading.
This important subject is often made needlessly complex. Option traders are not modelling specialists, and do not need to be. Option prices (or premiums) have two components; prices are determined by six factors; and the way prices change are measured by six indicators (called Greeks).
The price of any option (call or put) has two components
INTRINSIC VALUE: Intrinsic value reflects the amount, if any, by which an option is In-the-money (ITM).
TIME VALUE: Time Value is the amount of money you pay for the length of time until the option expires.
NOTE VERY WELL:Learn about Time Value in options trading.
The Price of any option is influenced by six factors:
- The price of the underlying stock: as the stock goes up, the price of a call option increases and that of a put option decreases. The reverse is true when the stock goes down. The RATE of this change is measured by a Greek symbol called DELTA.
- The strike price of the option (relative to the stock price). This determines the INTRINSIC value of the option. If the option strike price is OTM (Out-of-the-money)(i.e. for a call option, the strike price is higher than the price of the underlying stock), it has no intrinsic value. An option has intrinsic value when it is ITM (In-the-money)(i.e. for a call option, the underlying stock price is higher than the strike price).
- The Time Value of the option.You pay extra money to buy extra time for the life of your option. This is VERY IMPORTANT concept for option traders. The rate of change of Time Value is measured by a Greek symbol call THETA.
- Volatility. If a stock is volatile, the option prices will be high; if the stock is not volatile, the option prices will be low. This is another IMPORTANT concept. Volatility has two components - Historical Volatility (measured by a Greek symbol called VEGA) and Implied Volatility (measured by a Greek symbol called ZETA).
- Interest rates. This factor does not need to interest option traders.
- Stock dividends. This factor does not need to interest option traders.
Here is a Video on Option Pricing Theory:
WHAT ABOUT THE GREEKS?
Options prices and changes in these prices are measured by six indicators called GREEKS. The six Greeks are DELTA, GAMMA, THETA, VEGA,RHO and ZETA. Unless you are researching a doctoral thesis on the minute details of options, and are a mathematical and statistical genius of some note, most of the detail these measurements are not relevant to the average trader who just wants to make a profit. Learn the concepts, and learn how to recognise patterns that are important to trading. Leave the modelling to little men with big glasses and lots of pens in their shirt pockets.
TOP TIP: Click here for a free 5 minute primer in Option Greeks
A simple summary:
- DELTA measures the rate at which an option price will change relative to the stock price. Equivalent to SPEED.
- GAMMA measures the rate at which DELTA changes. Equivalent to acceleration.
- THETA measures the rate of change of time value.
- VEGA measures the Historical Volatility
- RHO measures the sensitivity of the option price relative to changes in the Risk Free Interest Rate. This factor does not need to interest option traders.
- ZETA is a measure of IMPLIED VOLATILITY
So, What Next?
Here is what you need to know:
If you are SELLING options: You absolutely must understand the concept of Time Value and Time Decay. You can keep an eye Theta, but if you can count the number of weeks on ONE hand until expiration, you are in a good place to sell options. Knowing about Volatility (in general) helps because high volatility stocks give better option premiums and therefore better profits (and slightly higher risk).
If you are BUYING options: You need to understand FOUR things: Intrinsic Value, Time Value, Delta and Volatility. You can choose to buy DITM Options (and so maximise the leverage of DELTA) or OTM Options (and so maximise the leverage of Intrinsic Value). You need to know about Time Decay so that you give your option enough time to move, but also to understand that as long as you hold on to that option, Time is eating away at your profits. Finally, Volatility (measured by VEGA and ZETA) helps you find a good entry point so that you buy options that are cheap or at fair value, and sell when they are expensive. Note: This is the only area where I actually recommend the help of software in dealing with this factor. Let the computer do the work for you. Option University's Volcone Analyser Pro is the best for this.
If you trade volatility trades, such as strangles and straddles, then you need to have a good idea of how volatility works.
THAT'S IT!
You can learn more about the two components of Option Value (Intrinsic Value and Time Value) on this page.
You can learn about the Greeks and their uses on this page.
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