THE ESSENTIALS OF OPTION PRICE
Options enable buyers to purchase or sell a security at a preset price on or before the contract expires. Commonly used in the stock market, options can also be used in commodity, forex, and futures markets. There are many types of options, including exchange options, exotic options, and flexible options. But this article will focus on the options being used in the stock market, specifically, option pricing.
Option Buyers and Their Objectives
Investors use option contracts to either hedge positions, as well as to buy and sell stock, or to speculate. Normally, speculators have no intention of exercising the contract, but hope to seize a move in the stock without paying a large amount of money.
One of the common mistakes among options investors is purchasing in anticipation of a well-publicized event such as drug approval or earnings announcement. Speculators do not realize option markets are more efficient than them. Investors, market makers, and traders are normally aware of upcoming events and buy up contracts, pushing the price up, and costing the investor more money.
The largest success driver is the stock’s price movement when buying a contract. A call buyer escalates the stock; a put buyer drops the stock. The option’s premium is divided into two parts: intrinsic value and extrinsic value. Similar to home equity, intrinsic value refers to the amount of the premium’s value driven by the stock’s actual price.
Options with intrinsic value are considered in the money (ITM) while those without intrinsic value, but extrinsic value, are said to be out of the money (OTM). Options with greater extrinsic value are less responsive to the stock’s price movement. Those with higher intrinsic value are more synchronized with the stock’s price. Delta is the option’s sensitivity to the stock’s movement.
Delta, sometimes referred to as the hedge ratio, is the ratio used to compare the change in the price of the given asset and the change in the price of a derivative. A delta of 1.0 indicates the option will possibly move dollar per dollar with the stock. A delta of 0.6 implies the option will move about 60 cents on the dollar. The delta for puts is described as a negative number, showing the reverse relations of the put to the stock’s movement.
Sometimes called the time value, that is partly correct. This value is made up of implied volatility which fluctuates as demand for options shift. At some point, interest rates and stock dividend changes influence the movements. But these elements are too small to worry about in this article. So this will concentrate on time value and implied volatility.
Time value pertains to the portion of the premium above intrinsic value an option buyer pays for the privilege of possessing the contract over a specific period. The time value premium drops as the contract’s maturity draws near. The longer the expiration, the more time premium a buyer will pay for. Conversely, the closer the expiration, the faster the time value fades. The Greek letter theta gauges time value. Buyers need to get the efficient market timing because theta consumes it little by little at the premium, profitable or not.
Another common mistake committed by option investors is allowing a profitable trade to stay long, long enough that theta cuts the profits substantially. Investors must be able to set a clear exit strategy for being right or wrong before purchasing an option.
Aside from time value, implied volatility is the other key portion of extrinsic value, also called vega to option investors. An investor needs to edge in option buying since vega inflates the premium. Popular events such as earnings or drug trials often generate less profits for buyers than originally projected.
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