How To Get Started In Options Trading, Part II
Pricing
Options can be classified as being in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). A call option is in-the-money if the strike price is less than the current market price. For example, if XYZ is trading at $50 and you purchase an XYZ February 40 Call, your option is in-the-money. The buyer of an in-the-money call would be able to purchase stock for less than the current market price. Since in-the-money calls allow the buyer to purchase stock at less than market price, they command the premium. ITM options have a tendency to move almost point-for-point with the stock. Many traders use ITM options as a stock substitute.
A call option is at-the-money if the strike price equals or is very near the current market price of the stock. For example, if XYZ is trading at $50 and you purchase an XYZ February 50 call, your option is at-the-money. The cost of an at-the-money call is lower than that of an in-the-money call, but higher than an out-of-the-money call. Lastly, a call option is out-of-the-money if the strike price is greater than the current market price. For example, if XYZ is trading at $50 and you purchase an XYZ February 60 call, your option is out-of-the-money. out-of-the-money calls have the lowest premiums, but they give you the most bang for the buck. So if you think a stock will make a quick and large move up, buy OTM calls.
For put options, puts are in-the-money if the strike price is greater than the current market price. For example, if XYZ is trading at $50 and you purchase an XYZ February 60 put, your put is in-the-money. Since in-the-money puts allow you to sell at a price that is greater than the current market price, they have the highest premiums. A put option would be at-the-money if the strike price were equal to the current market price. For example, if XYZ is trading at $50, and you purchase an XYZ February 50 put, then your put is at-the-money. At-the-money puts have lower premiums than in-the-money puts and higher premiums than out-of-the-money puts. Finally, a put option is out-of-the-money if the strike price is less than the current market price. For example, if XYZ is trading at $50 and you purchase an XYZ February 40 put, your put option is out-of-the-money. Buy OTM puts when you think that a stock will have a quick and large move down.
ITM options have a tendency to move almost point-for-point with the underlying stock. The prices of ITM options are very sensitive to the movements of the underlying stock. The option’s delta is a statistical measure of the option’s sensitivity to changes in the underlying stock price. Option deltas are actually a statistical probability that range from zero to one for call options and zero to negative one for put options. For example, if Cisco stock is up a dollar today and the January 35 call is up fifty cents, then the call’s delta is .50. Delta could be expressed in decimal or percentage form. Delta could be roughly calculated as:
Change In Option Price / Change In Stock Price = Option Delta.
An option’s value consists of two components, intrinsic value and time value. Intrinsic value is the amount of the option that is in-the-money. For example, if XYZ is currently trading at $50 and you hold a February 40 call, then your call has an intrinsic value of $10. If you hold a February 60 call, then your call would have an intrinsic value of $0. The other component of an option is time value. Time value is the difference between the option’s current price and its intrinsic value. For example, if the February 40 call is currently trading at 10 1/2, then time value is calculated as
10 1/2 Option Price -10 Intrinsic Value = 1/2 Time Value
Due to the length and complexity of the actual option-pricing formula, we will not go over the actual calculation in this lesson. However, we will discuss the six factors that determine the value of an option and are the actual inputs to the Black-Scholes option pricing formula.
The six factors that affect option prices are:
1. Price of the underlying instrument – This is the most important factor. The higher the price of the underlying instrument, the higher the price of the option. The lower the price of the underlying instrument, the lower the price of the option. If all things remain constant, as the price of the underlying increases, call prices increase and put prices decrease. And as the price of the underlying decreases, put prices increase and call prices decrease.
2. Strike Price – It is the strike price that determines whether an option is ITM, ATM or OTM. The strike price also determines whether an option has intrinsic value. Remember that when you buy OTM options, all you’re buying is time.
3. Time – the more time till expiration, the more time you have for an option to move in your favor. So, more time will cost you more money. A three-month option will cost more than a one-month option. It’s important to know that an option is a wasting asset. With each passing day, an option will lose some of its time value; this is known as “time decay.†Time decay will accelerate in the last weeks and days of an option’s life.
4. Interest Rates – Interest rates have a minor effect on option prices. Despite this, it’s still important to know that as interest rates increase, call prices increase and put prices decrease. To understand this dynamic, think of call buying as a cheap alternative to buying stock. The call buyer in turn will save the difference between the amount spent on the call and the amount that would have been spent on the stock. The higher the interest rate, the more money you would earn by investing the money you saved by buying the call. So, if interest rates were increasing, traders would buy calls and drive prices up.
5. Dividends – as dividends increase, call prices decrease and put prices increase. This is because as a company increases their dividends, the stock will drop by that amount on the ex-dividend date. So if dividends increase, the stock will drop by a bigger amount and lower stock prices equals lower call prices and higher put prices.
6. Volatility – volatility is a measure of price fluctuation. Volatility does not have a bias in direction. More volatility means more ups and downs. An increase in volatility means a greater likelihood that the option will become profitable. So as volatility increases, both call and put prices increase.