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You might have had success beating the market by trading stocks using a disciplined process that anticipates a nice move either up or down. Many traders have also gained the confidence to make money in the stock market by identifying one or two good stocks that may make a big move soon. But if you don't know how to take advantage of that movement, you might be left in the dust. If this sounds like you, then maybe it's time to consider using options to play your next move. This article will explore some simple factors that you must consider if you plan to trade options to take advantage of stock movements.
Option Pricing Before venturing into the world of trading options, investors should have a good understanding of the calculate put option value option that calculate put option value option the value of an option. These include the current stock price, the intrinsic valuetime to expiration or the time valuevolatilityinterest rates and cash dividends paid.
If you don't know about these building blocks, check out our Option Basics and Options Pricing tutorials. There are several options pricing models that use these parameters to determine the fair market value of the option. Of these, the Black-Scholes model is the most widely used. In many ways, options are just like any other investment in that you need to understand what determines their price in order to use them to take advantage of moves the market. Main Drivers of an Option's Price Let's start with the primary drivers of the price of an option: current stock price, intrinsic value, time to expiration or time value, and volatility.
The current stock price is fairly obvious. The movement of the price of the stock up or down has a direct - although not equal - effect on the price of the option. As calculate put option value option price of a stock rises, the more likely the price of a call option will rise and the price of a put option will fall.
If the stock price goes down, then the reverse will most likely happen to the price of the calls and puts. For related reading, see ESOs: Using The Black-Scholes Model. Intrinsic Value Intrinsic calculate put option value option is the value that any given option would have if it were exercised today. Basically, the intrinsic value is the amount by which the strike price of an option is in the money.
It is the portion of an option's price that is not lost due to the passage of time. The following equations can be used to calculate the intrinsic value of a call or put option : The intrinsic value of an option reflects the effective financial advantage that would result from the immediate exercise of that option. Basically, it is an option's minimum value.
Options trading at the money or out of the money have no intrinsic value. It is also important to note that intrinsic value also works in the same way for a put option. Time Value The time value of options is the amount by which the price of any option exceeds the intrinsic value. It is directly related to how much time an option has until it expires as well as the volatility of the stock.
The formula for calculating the time value of an option is: The more time an option has until it expires, the greater the chance it will end up in the money. The time component of an option decays exponentially. The actual derivation of the time value of an option is a fairly complex equation. As a general rule, an option will lose one-third of its value during the first half of its life and two-thirds during the second half of its life. This is an important concept for securities investors because the closer you get to expiration, the more of a move in the underlying security is needed to impact the price of the option.
Time value is often referred to as extrinsic value. To learn more, read The Importance Of Time Value. It is like an insurance premium of the option; the higher the risk, the higher the cost to buy the option. Notice that the intrinsic value is the same and all the difference in the price of the same strike price option is the time value. An option's time value is also highly dependent on the volatility in that the market expects the stock will display up to expiration.
For stocks where the market does not expect the stock to move much, the option's time value will be relatively low. The opposite is true for more volatile stocks or those with a high betadue primarily to the uncertainty of the price of the stock before the option calculate put option value option. In the table below, you can see the GE example that has already been discussed.
It shows the trading price of GE, several strike prices and the intrinsic and time values calculate put option value option the call and put options. AMZN is a much more volatile stock with a beta of 3. Compare the GE 35 call option with nine months calculate put option value option expiration with the AMZN 40 call option with nine months to expiration. This makes - an option seller of GE will not expect to get a substantial premium because the buyers do not expect the price of the stock to move significantly.
On the other hand, the seller of an AMZN option can expect to receive a higher premium due to the volatile nature of the AMZN stock. Basically, when the market believes a stock will be very volatile, the time value of the option rises. On the other hand, when the market believes a stock will be less volatile, the time value of the option falls.
It is this expectation by the market of a stock's future volatility that is key to the price of options. Keep reading on this subject in The ABCs Of Option Volatility. The effect of volatility is mostly subjective and it is difficult to quantify. Fortunately, there are several calculators that can be used to help estimate volatility. To make this even more interesting, there are also several types of volatility - with implied and historical being the most noted. When investors look at the volatility in the past, it is called either historical volatility or statistical volatility.
Historical Volatility helps you determine the possible magnitude of future moves of the underlying stock. Statistically, two-thirds of all occurrences of a stock price will happen within plus or minus one standard deviation of the stocks' move over a set time period. Historical volatility looks back in time to show how volatile the market has been. This helps options investors to determine which exercise price is most appropriate to choose for the particular strategy they have in mind.
To read more about volatility, see Using Historical Volatility To Gauge Future Riskand The Uses And Limits Of Volatility. Implied volatility is what is implied by the current market prices and is used with the theoretical models. It helps to set the current price of an existing option and assists option players to assess the potential of an option trade. Implied volatility measures what option traders expect future volatility will be. As such, implied volatility is an indicator of the current sentiment of the market.
This sentiment will be reflected in the price of the options helping options traders to assess the future volatility of the option and the stock based on current option prices. The Bottom Line A stock investor who is interested in using options to capture a potential move in a stock must understand how options are priced. Besides the underlying price of the stock, the key determinates of the price of an option are its intrinsic value - the amount by which the strike price of an option is in-the-money - and its time value.
Time value is related to how much time an option has until it expires and the option's volatility. Volatility is of particular interest to a stock trader wishing to use options to gain an added advantage. Historical volatility provides the investor a relative perspective of how volatility impacts options prices, while current option pricing provides the implied volatility that the market currently expects in the future.
Knowing the current and expected volatility that is in the price of an option is essential for any investor that wants to take advantage of the movement of a stock's price. Term Of The Day A regulation implemented on Jan. Tour Legendary Investor Jack Bogle's Office. Louise Yamada on Evolution of Technical Analysis. Financial Advisors Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.
The following equations can be used to calculate the intrinsic value of a call or put option :. The intrinsic value of an option reflects the effective financial advantage that would result from the immediate exercise of that option. The formula for calculating the time value of an option is:. The more time an option has until it expires, the greater the chance it will end up in the money. General Electric is considered a stock with low volatility with a beta of 0. Figure 1: General Electric GE.
A thorough understanding of risk is essential in options trading. So is knowing the factors that affect option price. Options can be an excellent addition to a portfolio. Find out how to get started. Learn more about stock options, including some basic terminology and the source of profits. Understand why the concept of intrinsic value is important for options traders and how they can use it to estimate what a Explore how options can provide risk, which is precisely defined Hot Definitions A regulation implemented on Jan.
A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving A short-term debt obligation backed by the U. T-bills are sold in denominations A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical Return on market value of equity ROME is a comparative measure typically used by analysts to identify companies that generate The majority shareholder is often the founder No thanks, I prefer not making money.
The Options Premium
Using the Black and Scholes option pricing model, this calculator generates theoretical values and option greeks for European call and put options. Toggle navigation. Option Pricing Basics Aswath Damodaran. A Summary of the Determinants of Option Value Factor Call Value Put Value Increase in Stock Price Increases Decreases. Video embedded · Understanding Option Pricing The following equations can be used to calculate the intrinsic value of a call or put Put Option Intrinsic Value = Put.