Option Price Components (Part 2)

Go back to “Part 1”

EXAMPLES FOR INTRINSIC VALUE & TIME VALUE CALCULATION:

For Call Option:
Current stock price = $30.
The price of Call option with Strike Price of $20 = $12
This call option is In-The-Money (ITM) option because Strike Price ($20) < Stock Price ($30).
Intrinsic Value = Stock Price – Strike Price = $30 – $20 = $10.
Time value = Option price – Intrinsic Value (if any) = $12 - $10 = $2
Here, the call option is said to be In-The-Money with intrinsic value of $10, as it allows the call option buyer to immediately buy a $30 stock at $20 the moment he bought it.

Current stock price = $30.
The price of Call option with Strike Price of $40 = $0.5
This call option is Out-Of-The-Money (OTM) option because Strike Price ($40) > Stock Price ($30).
Intrinsic Value = 0 (No intrinsic value for OTM option)
Time value = Option price – Intrinsic Value (if any) = $0.5
Here, the call option is called Out-Of-The-Money, as it is better for the call option buyer to buy the stock from the market at $30 than to immediately exercise the option at $40 strike price.


For Put Option:
Current stock price = $30.
The price of Put option with Strike Price of $35 = $6.
This put option is In-The-Money (ITM) option because Strike Price ($35) > Stock Price ($30).
Intrinsic Value = Strike Price – Stock Price = $35 – $30 = $5.
Time value = Option price – Intrinsic Value = $6 - $5 = $1.
Here, the put option is said to be In-The-Money with intrinsic value of $5, as it allows the put option buyer to immediately sell a $30 stock at $35 the moment he bought it.

Current stock price = $30.
The price of Put option with Strike Price of $25 = $0.3.
This put option is Out-Of-The-Money (OTM) option because Strike Price ($25) < Stock Price ($30).
Intrinsic Value = 0 (No intrinsic value for OTM option).
Time value = Option price – Intrinsic Value (if any) = $0.3.
Here, the put option is called Out-Of-The-Money, as it is better for the put option buyer to sell the stock in the market at $30 than to immediately exercise the option at $25 strike price.

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Option Price Components (Part 1)

The price of an option consists of 2 main components:
Intrinsic Value and Time Value (Time value is also known as Extrinsic Value).

OPTION PRICE = INTRINSIC VALUE + TIME VALUE

Intrinsic Value is the value that is already built into the option the moment you bought it. Or in other words, the value by which an option is "in-the-money".
Time Value is the difference between an option’s price and its intrinsic value. As the option nears expiration, the time value erodes and eventually becomes zero.

Only In-the-Money (ITM) option has intrinsic value.
For At-The-Money (ATM) and Out-Of-The-Money (OTM) options, the intrinsic value is zero, therefore the option price comprises of only time value. Therefore:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

HOW TO CALCULATE INTRINSIC VALUE & TIME VALUE:

Intrinsic Value of ITM Call Option:
Intrinsic Value = Current Stock Price – Strike Price.

Intrinsic Value of ITM Put Option:
Intrinsic Value = Strike Price – Current Stock Price.

Time Value of All Options (ITM, ATM, OTM):
Time value = Option price – Intrinsic Value (if any)

As a result, the deeper we move into the money, the higher the option price will be (as it has more intrinsic value). The further we go out of the money, the cheaper the option price would be.
The option prices will change throughout the trading day based on the underlying stock movement, volatility and time.

Continue to “Part 2”

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In-The-Money, At-The-Money, and Out-Of-The-Money Options (Options Moneyness)

Options Moneyness
Options Moneyness is the relationship between an option’s Strike Price with the current price of the underlying security (i.e. stock price).

There are 3 states of Options Moneyness:
* In The Money (ITM)
* At The Money (ATM)
* Out Of The Money (OTM)
As the stock price moves, an option would move from one moneyness state to another.

Whether an option is In The Money (ITM), At The Money (ATM), and Out of The Money (OTM) is determined by the relationship between an option’s Strike Price with stock price (i.e. where the Option’s Strike Price is in relation to the current stock price).
This relationship is also depending on the types of options, i.e. whether it is Call or Put option.

For Call Option:
Call options is called “In The Money (ITM)” if the Strike Price is less than the current stock price, because the call option buyer has the right to buy the stock at the price that is less than the price he would have to pay if he buys the stock in the market.
Call options is called “At The Money (ATM)” if the Strike Price is equal to the current stock price.
And Call options is called “Out Of The Money (OTM)” if the Strike Price is more than the current stock price, because it will be cheaper to buy the stock from the market than to exercise the call option.

For Put Option:
Put options is called “In The Money (ITM)” if the Strike Price is more than the current stock price, because the put option buyer has the right to sell the stock at the price that is more than the price he would receive if he sells the stock in the market.
Put options is called “At The Money (ATM)” if the Strike Price is equal to the current stock price.
And Put options is called “Out Of The Money (OTM)” if the Strike Price is less than the current stock price, because it will be better off to sell the stock in the market than to exercise the put option.

Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks

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Options Pricing

Options Pricing:
* In-The-Money, At-The-Money, and Out-Of-The-Money Options (Options Moneyness)
* Option Price Components
* Option Chain
* Option Pricing: How Is Option Priced?

Options Volume, Open Interest & Bid-Ask Price Spread:
* Difference Between Option’s Volume and Open Interest
* How To Determine Options Liquidity?


Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic – Part 1
* Understanding Implied Volatility (IV)
* Understanding Option’s Time Value
* Option Greeks
* Learning Candlestick Charts
* Learning Charts Patterns

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Potential Risk & Rewards of Options Buyer vs. Seller

Potential Risk & Rewards of Options Buyer
The maximum loss of a buyer of an option is the initial premium he pays for the contract, regardless of what happens to the stock. So, the risk to the buyer is limited, never more than the amount spent to buy the options, but the potential profit is theoretically unlimited.

Potential Risk & Rewards of Options Seller
On the contrary, in return for the premium received from the buyer, a seller of an option would need to take on the risk of having to sell (for calls) or buy (for puts) the stocks should the buyer decides to exercise his right. If that option is not covered by another option or a position in the underlying stock, the seller's loss can potentially be unlimited. Writing options without covered by another options (e.g. spreads) or a position in the underlying stock (e.g. covered call/put) is called writing Naked (Uncovered) Options. Since writing naked options has only a limited profit (i.e. the premium received) but is exposed to unlimited potential risk, it is not an advisable thing to do, especially for beginners.











For beginners, it’s much simpler just to buy calls if you expect a stock will increase or puts if you expect a decrease, which offers limited risk and unlimited potential profit. Only after you get more trading experiences and completely familiar with how options work, you may then choose to move on to learning more complex option strategies, which allow you to be a seller without getting exposed to unlimited risk.

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When Should You Buy / Sell Call or Put Option?

As we know, buyers would profit if they buy a security at lower price and sell it at a higher price (Buy Low, Sell High), while Sellers would profit if they sell a security at higher price and then buy it back to close their position at a lower price (Sell High, Buy Low).

Since Call option price goes up when the underlying stock’s price goes up, and vice versa, we would buy a Call Option if we are bullish and expect a stock will increase before option expires.
On the other hand, we will sell or "write" a Call Option if we are bearish and anticipate a drop in the underlying stock’s price before the option’s expiration date, or if we expect the stock price to move sideways.

As for Put options, since Put option price increases when the underlying stock’s price decreases, and vice versa, we will buy a Put Option if we are bearish and foresee a stock will move downwards before option expiration. Conversely, we will sell or “write” a Put Option if we are bullish and expect a stock will move up before option expires, or if we think the stock price will go nowhere.

However, before you decide if you should be a buyer or seller, it is extremely crucial to understand potential risk & rewards for options buyer vs. seller.

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Options Buyer vs Seller

There are 4 participants in the options markets:
1. Buyers of Call options
2. Sellers of Call options
3. Buyers of Put options
4. Sellers of Put options

People who buy options are called “buyers” or “holders”, and those who sell options are called “sellers” or “writers”. Buyers are said to have “long” positions, and Sellers are said to have “short” positions.

Buyers open a position in the market by buying a security and close a position by selling the security. Whereas Sellers open a position by selling a security and close a position by buying back the security.

When the buyer of the option contract uses the right to buy or sell the security, it is called to “exercise” the option.

On the contrary, when the seller of the option contract is obligated to sell or buy the security when the buyer chooses to exercise the option, it is said that the sellers has got “assigned”. Once he is assigned, he must fulfill his obligation to sell or buy the security as per contract. To avoid assignment, sellers need to close their position by buying back the options.

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What is Put Option?

Put option is a contract that gives the buyer of the options the right to sell the underlying security at a particular price (i.e. strike price) on or before a certain date (i.e. expiration date).
The seller (or writer) is, in turn, obligated to buy the security should the buyer chooses to exercise the option.

Put option’s price increases when the underlying stock’s price decreases, and decreases as the underlying stock’s price increases (negative relationship).
As such, we will buy a Put Option if we think that a stock will move downwards.

Example:
Using the above Company ABC example, if you anticipate the stock to drop from $23 per share, you can buy a Put option for $90 (or $0.9 per share) that gives you the right to sell 100 shares of ABC at $22.5 per share anytime in the next 90 days.

If the stock falls to $20 per share before option’s expiration:
1) You can, in theory, buy 100 shares in the open market for $20 per share and then exercise your put option which gives you the right to sell the stock at $22.5 per share. Your profit will be $1.6 per share (22.5 – 20 = 2.5 – 0.9 for option premium = $1.6 per share).

2) In practice, you would just sell your put option, which would now have a value of at least $2.5 per share (intrinsic value only) and profit by $1.6 per share (2.5 – 0.9 for option premium = $1.6 per share).

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What is Call Option? (Part 2)

Click here to go back to “What is Call Option? (Part 1)”

Example:
Company ABC is currently trading at $23 per share. You believe the stock will be going up within a short time period. Hence you buy one contract of Call option that gives you the right, but not the obligation, to buy 100 shares of the company anytime in the next 90 days for $25 per share. The option’s price is $0.5, so you will buy one option contract for $50 (multiplied by 100 shares per contract).

If your prediction is right and the stock rises to $ 28 per share before the option expires, there are 2 alternatives you can do:
1) You could exercise your option and buy 100 shares at $25 per share and sell them for an immediate profit of $2.5 per share ($28 - $25 = $3 - $0.5 for the option premium = $2.5 per share). However, as a practical matter, options traders rarely choose this alternative.

2) You could simply sell the option contract for a profit without actually buying the shares of stock. When the stock price increases to $28, the option price would at least be worth of $3.00 (intrinsic value only). Hence, you will also gain $2.5 per share ($3 - $0.5 for the option premium = $2.5 per share). This is what options traders will normally do.

On the other hand, if your prediction is wrong and the stock moves nowhere or drops from the original $23 to $21 per share, you would simply let the option expire worthless and suffer only a $50 loss (the option price), because in this case, most likely the option would have no value.

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What is Call Option? (Part 1)

Call option is a contract gives the buyer of the options the right to buy the underlying security at a particular price (i.e. strike price) on or before a certain date (i.e. expiration date).
The seller (or writer) is, in turn, obligated to sell the security should the buyer decides to exercise the option.

Call option’s price increases when the underlying stock’s price increases, and decreases as the underlying stock’s price decreases (positive relationship).
Hence, typically we will buy a Call Option if we expect a stock will go up before option expires.

Click here to continue to "What is Call Option? (Part 2)"

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Stock Option Contract Specification

An option contract specifies the following:

• The underlying stock (e.g. AAPL, DELL, MSFT, etc.)
• The Expiration Date of the contract (i.e. Third Friday of the Expiration Month)
• The Strike Price (or Exercise Price)
• Option Type: Call or Put option
• The Price of the option contract, which is often called “Premium”
• Number of option contracts

By default, one option contract represents 100 shares in the underlying stock, whereas the quoted price of an option is per share. Hence, the quoted price of an option must be multiplied by 100 to get the cost of option per contract.

The common format to specify stock option contract is as follow:

The underlying stock ticker, Expiration Month, Strike Price, Call / Put

Example:
AAPL May 95 Call refers to Call option for Company AAPL (Apple Inc.) with Strike Price of $95 and Expiration Date of the third Friday of May.
Suppose you buy 2 AAPL May 95 Call with option price of $5, the total cost will be: 2 contracts x 100 shares/contract x $5 = $1,000.

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Stock Trading vs Options Trading

Option trading is much more complex and risky as compared to stock trading.
When investing in stocks, you only have to worry about one thing, which is price; whereas in options trading, there are additional variables that influence an option's price.

In order to be profitable in stock, you need to be right in the expected direction of underlying stock price movement. In options, on top of that, you also have to be right in the expected magnitude of the movement as well as the time needed for the movement to happen. As a buyer of an option, you will want the expected movement to occur quite soon so that the time value lost will be minimal, and the magnitude of movement is big enough to cover the loss in time value while waiting the stock to move. If either of these two is wrong, you might still lose money although the direction is correct.

Additionally, due to the leverage effect, if you are wrong, if you could have higher % loss from options trading than from stock trading, given the same move in the underlying stock price. Although in terms actual dollar, the loss from options trading should be smaller than it does from stock trading, provided the number of shares are the same.

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Why Option Trading? (Part 2)

Click here to go back to “Why Option Trading? (Part 1)”

3. Leverage

You can potentially have greater % return of investment from options trading than from stock trading, given the same move in the underlying stock price.

For example:
A stock price of Company ABC (currently trading at $96) is expected to increase significantly over the next few weeks. The Call option price for that stock with Strike Price of $95 and 45 days to expiration is $6.
If you buy 100 shares of that stock, you need to invest $9,600 to purchase the stock. Assuming the stock price increases to $105 within 15 days, you would gain $ 900 (= 10,500–9,600) or 9% (= 900/9,600).
But if you buy 1 Call option contract for that stock instead (that gives the right to buy 100 shares), the cost will only be $600. When the stock price rises to $105, the option price may increase to $11 and you can then sell the option with a gain of $ 500 (=1,100–600) or 83% (=500/600).
As you can see, given the same number of shares, you get much higher % return using options (83%) than stocks (9%), although it is smaller in terms of actual dollar.

If, say, you buy 2 contracts of Call option for $1,200, you can gain $1,000, comparable to the dollar gain from the stock investment ($900). So, buying options allow you to gain the same profit as stocks would with only a much smaller capital and, therefore, at a much lower risk than buying stocks. In the worst case, if the stock crashes, the most you can lose is $1,200 and not the full $9,600.

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Why Options Trading? (Part 1)

There are a few reasons why people use options:

1. Require less capital

Options trading generally require less capital than the corresponding stock trading, because option price is only a small fraction of the underlying stock price. When a trader is confident that a stock price will move in a particular direction significantly within a short term, he can invest in options rather than in the stock itself to take advantage of the expected movement because of the limited risk, high potential reward and smaller amount of capital required to control the same number of shares of stock.

2. Protection

For an investor who invests in stocks, put options can be used as a hedging tool to protect your stocks from a price drop. When the stock price drops, the put option will increase in value, hence offsetting the loss in the stock. When the stock rises, the put option would simply expire worthless when the expiration date comes and you will only lose the price you paid to purchase the put options. So, here as if you buy put options as an insurance policy to protect your stocks from a price fall.

For an option trader, when the stock does not move in the expected direction, you should lose much lesser than a stock trader (in terms of dollar). Because the maximum you can lose is limited to the amount you spent to buy the option (premium), which is only a small fraction of the underlying stock price.

Click here to continue to "Why Options Trading? (Part 2)"

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What is Option Trading?

Option Trading is buying or selling option contracts in an exchange.
In the US, there are 6 exchanges that are trading listed/standardized stock options:

1. Chicago Board Options Exchange (CBOE)
2. The Philadelphia Stock Exchange (PHLX)
3. American Stock Exchange (AMEX)
4. Boston Options Exchange (BOX)
5. International Securities Exchange (ISE)
6. NYSE Arca in New York City

An option trader can trade (buy / sell) options via brokers with option trading services. The broker will buy and sell options in any of the above exchanges on behalf of the trader and will charge the trader a fee or commission for that service. Options trading is generally conducted through online option trading brokers, which offer lower commission charges and relatively faster transaction execution speed.

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American vs European Style Options

There are 2 styles of stock option: American Style Options and European Style Options.
The difference between American and European style options relates to when the options can be exercised:

• American Style Options can be exercised at any time before or on the expiration date. Most of exchange-traded options are this style. Currently, all stock options in the US market are American style.
• European Style Options can be exercised only at the expiration date.

Note:

• American or European styles do not imply where the stock options are being traded. It does not mean that stock options traded in the US exchanges are American style and those traded in European exchanges are European style. Most stock options traded in European exchanges are American style options too.
• Since American options provide more flexibility than European options, the price of American option will at least be equal to or higher than European option.
• To option traders, the difference between the two styles is not very important because option traders rarely intend to exercise their options. Option traders typically just want to trade options for a profit with a much lesser capital with no intention to take possession of the underlying stock. Nevertheless, option sellers might need to be more cautious with American style options due to the possibility of early assignment.

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Do All Stocks Offer Stock Options?

Not all stocks have stock options traded publicly in the exchanges. Stocks that offer publicly traded stock options in the exchanges for option trading are called Optionable Stocks.
The following are 4 criteria a company must meet in order for their stock options to be traded publicly in the option exchanges:

1. The stock must be listed on the NYSE, AMEX or Nasdaq.
2. The company must have >= 2,000 shareholders.
3. The company must have >= 7 million publicly held shares.
4. The closing price must have a minimum per share price for a majority of trading days during the three prior calendar months. (Note: Therefore, a company that had just launched its IPO has to wait for at least 3 months to have its options publicly traded in the exchanges, provided that it also fulfills all the other criteria).

Source: Investopedia

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What is Stock Option?

A stock option is a contract that gives the buyer of the contract the right, but not the obligation, to buy or sell a security at a certain price (i.e. strike price) on or before a certain date (i.e. expiration date).

After this expiration date, the option would cease to exist. In the US market, stock options expire on the third Friday of each expiration month. If that Friday is a holiday, then the options expire on Thursday.

Note:
Stock option here does not refer to the Employee Stock Option, but to exchange-traded option.
Here are the differences between Employee Stock Option and exchange-traded option.

Employee Stock Option:

• Issued & granted by a company to an employee, generally to reward the employee’s contribution & loyalty.
• Long term expiration period (like 5 to 10 years) so as to cultivate loyalty among the employees.
• Not transferable (Cannot be sold or traded to a third party).

Exchange-traded Stock Option:

• Not issued by the company itself, but by OCC (Options Clearing Corporation).
• Shorter expiration, usually only a few months (except for LEAPS). LEAPS (Long-Term Equity Anticipation Securities) is an option contract with a very long expiration period (9 months or more).
• Can be traded (bought or sold) at any time before expiration.

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Options Trading Basic

Click the following links to read each of the articles:

* What is Stock Option?
* Do All Stocks Offer Stock Options?
* American vs European Style Options
* What is Option Trading?
* Why Option Trading?
* Stock Trading vs Option Trading
* Stock Option Contract Specification
* What is Call Option?
* What is Put Option?

Buying vs. Selling Options:
* Options Buyer vs Seller
* When Should You Buy / Sell Call or Put Option?
* Potential Risk & Rewards of Options Buyer vs. Seller



Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Understanding Option’s Time Value
* Option Greeks
* Learning Candlestick Charts
* Learning Charts Patterns

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Options Trading? What Is That?

I heard many people make a living from stock and options trading, and many can make lots of money and even became a millionaire from it. Wow, so wonderful! But is it that easy to make money from trading?

I became so interested to know more & even to learn about that. I knew a little bit about what options is from my financial management lesson during the uni days. But that’s only an introduction to options.
Where can I find out more about that? How can I learn the basic of option trading in practice? How does option work? What strategy to use? After all that, how to start trading? Which brokerage should I choose?

I knew there are many books & websites that we can read to learn options trading. But they are too many until I was confused which one is good to start with first. In fact, I know that many people have the same experiences too.

Therefore, as my first step here, I’d like to share my summary notes on Options Trading Basics. These notes summarize my readings from many sources (books or websites). Of course, this doesn’t mean that you don’t need to read books or other sources anymore. But the summary notes would highlight the important points that we need to remember, understand, and take note of on the basic of option trading. So, even for those who have read many options books, the notes may serve as a convenient reference in case you want to refer back or recall some important basics. Along the way, I will still add some more to the series, because I’d like to make it as a complete reference on the options basic for my own too.
Hope this can be useful.

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Trading is a Learning Journey

When I first started learning about options trading, I was really so overwhelmed. Oh my, there are so many things to learn! I still don’t understand this & that. Which one to start first? There are so many books & websites to learn from. I was so eager to learn, but it’s just too much until I couldn’t get focus. The more I read, the more I feel I still don’t know much and the more I hesitate to even start trading.

After some time, I realize that trading is not a one-time learning thing (many things are not too, actually). If you want to know everything before starting trading, then you will never trade. Of course, before you start trading at all, you need to prepare & equip yourself with enough trading knowledge. Afterwards, you will continue your learning journey as it goes. Because we are also learning from our own trades, both good & bad. And you will not stop learning until you stop trading.

Trading is not an easy business at all. Really. It needs lots & lots of hard work, but yet it’s enjoyable & exciting. And here I’d like to share these exciting learning experiences with you. And hope you will too by giving me your comments. So, let’s have fun in our learning journey in the world of trading!

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