Option Market
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset).
An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.
Option vs Stocks
In order for you to better understand the benefits of trading Options; you must first understand some of the similarities and differences between options and stocks.
Similarities:
Listed Options are securities, just like stocks.
· Options trade likes stocks, with buyers making bids and sellers making offer.
· Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
Options are derivatives, unlike stocks (i.e., options derive their value from something else, the underlying Security).
· Options have expiration dates, while Stocks do not
· There is not a fixed number of options, as there are with stock share available.
· Stockowners have a share of the company, with voting and dividend rights Options convey no such rights.
Call and Put option
Some people remain puzzled by options. The truth is that most people have been using options for some time, because option is built into everything from mortgages to auto insurance. In the listed options world, however, their existence is much clearer.
To begin, there are only two kinds of options:Call Options and Put Options.
Call Option:
These options are contracts that give the owner the right, but not the obligation to buy shares of a stock at a specified price (strike price) on or before the date of expiration.
A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits.
If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned.
If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instryment increases.
When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price.
If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.
Put Options:
These options are contracts that give the owner the right to sell a specified number of shares of a stock at a specified price (strike price).
Put Options are used when you expect the price of the underlying stock to go down.
Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies.
If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases.
If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.
With a Put Option, you can "insure" a stock by fixing a selling price.
If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level.
If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium.
This is the primary function of listed options, to allow investors ways to manage risk.
Option Premiums
The amount paid for an option. The option’s premium can be further broken down into intrinsic value and time value.
In this case, XYZ represents the option class while May 30 is the option series. All options on company XYZ are in the XYZ option class but there will be many different series.
An option Premium is the price of the option. It is the price you pay to purchase the option. For example, an XYZ May 30 Call (thus it is an option to buy Company XYZ stock) may have an option premium of $2.
This means that this option costs $200.00. Why? Because most listed options are for 100 shares of stock, and all equity option prices are quoted on a per share basis, so they need to be multiplied times 100.
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract. For example, with the XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 per share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock at $30 per share. The strike price also helps to identify whether an option is In the money, At the money, or Out of money when compared to the price of the underlying security.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist. The expiration date for all listed stock options in the U.S. is the third Friday of the month (except when it falls on a holiday, in which case it is on Thursday). For example, the XYZ May 30 Call option will expire on the third Friday of May.
OPTION PRICING
1. Intrinsic Value
This is a representation of the underlying stock price in relation the strike prices of the option. An option’s intrinsic value is the amount by which it is in-the-money.
For example: If you buy a call option and the underlying stock price increases, the intrinsic value of the call option will also increase.
Options are said to be:
A. At-the-Money
A term used to describe an option with a strike price equal to the market price of the stock. Because it is rare to see a stock trade exactly at the one of the strike prices, the term is normally used to mean the strike nearest the current stock price.
B. In-the-Money
This refers to call options with a strike below or put option with a strike above the current stock price are said to be in-the-money. This is also the amount of intrinsic value of the option – the amount that would be received if exercised immediately.
C. Out-of-the-Money
For call option, the strike price is ABOVE the current stock price, it is out-of-the-money. For example, ABC June $85 Call, where the current ABC stock price is $83, it is out-of-the-money by $2 ($85-$83).
For put option, the strike price is BELOW the current stock price, it is out-of-the-money. For example, ABC June $85 Put, where the current ABC stock price is $88, it is out-of-the-money by $3 ($88-$85).
Also, an option with no intrinsic value is used to be out-of-the-money.
2. Volatility
This portion of the option price is a representation of the historical and implied volatility in the stock market refers to the movement in the price of a security as a function of time.
For example: If a stock moves $1 in one day it is more volatile than a stock that moves $1 in one week. For the benefit of this higher relative volatility we must pay a higher price for the associated options.
3. Time Value
This is the cost of the time from the present to the date of expiration.
For example: The costs of a Wal-Mart May 45 call option will be more than the cost of a Wal-Mart March 45 call option.
In the example of the May 45 option, we will pay more for the benefit of having an added two months until expiration.
Think… why would this extra two months be worth paying for?
Consider the possibilities involved in the price changes in the underlying stock. Is it more likely that the underlying stock will move $1 in one month or three months than in one month?
We will then expect to pay a higher premium for the disadvantage of this added time.
OPEN INTEREST
“Open interest” refers to the numbers of outstanding contracts of a particular option. By knowing this number, we have a good indicator of the liquidity of the option.
Knowing the open interest of an option being considered for trade is critical!
So here is the rule concerning open interest:
Do not invest more than 10% of the open interest
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An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.
Option vs Stocks
In order for you to better understand the benefits of trading Options; you must first understand some of the similarities and differences between options and stocks.
Similarities:
Listed Options are securities, just like stocks.
· Options trade likes stocks, with buyers making bids and sellers making offer.
· Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
Options are derivatives, unlike stocks (i.e., options derive their value from something else, the underlying Security).
· Options have expiration dates, while Stocks do not
· There is not a fixed number of options, as there are with stock share available.
· Stockowners have a share of the company, with voting and dividend rights Options convey no such rights.
Call and Put option
Some people remain puzzled by options. The truth is that most people have been using options for some time, because option is built into everything from mortgages to auto insurance. In the listed options world, however, their existence is much clearer.
To begin, there are only two kinds of options:Call Options and Put Options.
Call Option:
These options are contracts that give the owner the right, but not the obligation to buy shares of a stock at a specified price (strike price) on or before the date of expiration.
A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits.
If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned.
If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instryment increases.
When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price.
If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.
Put Options:
These options are contracts that give the owner the right to sell a specified number of shares of a stock at a specified price (strike price).
Put Options are used when you expect the price of the underlying stock to go down.
Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies.
If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases.
If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.
With a Put Option, you can "insure" a stock by fixing a selling price.
If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level.
If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium.
This is the primary function of listed options, to allow investors ways to manage risk.
Option Premiums
The amount paid for an option. The option’s premium can be further broken down into intrinsic value and time value.
In this case, XYZ represents the option class while May 30 is the option series. All options on company XYZ are in the XYZ option class but there will be many different series.
An option Premium is the price of the option. It is the price you pay to purchase the option. For example, an XYZ May 30 Call (thus it is an option to buy Company XYZ stock) may have an option premium of $2.
This means that this option costs $200.00. Why? Because most listed options are for 100 shares of stock, and all equity option prices are quoted on a per share basis, so they need to be multiplied times 100.
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract. For example, with the XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 per share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock at $30 per share. The strike price also helps to identify whether an option is In the money, At the money, or Out of money when compared to the price of the underlying security.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist. The expiration date for all listed stock options in the U.S. is the third Friday of the month (except when it falls on a holiday, in which case it is on Thursday). For example, the XYZ May 30 Call option will expire on the third Friday of May.
OPTION PRICING
1. Intrinsic Value
This is a representation of the underlying stock price in relation the strike prices of the option. An option’s intrinsic value is the amount by which it is in-the-money.
For example: If you buy a call option and the underlying stock price increases, the intrinsic value of the call option will also increase.
Options are said to be:
A. At-the-Money
A term used to describe an option with a strike price equal to the market price of the stock. Because it is rare to see a stock trade exactly at the one of the strike prices, the term is normally used to mean the strike nearest the current stock price.
B. In-the-Money
This refers to call options with a strike below or put option with a strike above the current stock price are said to be in-the-money. This is also the amount of intrinsic value of the option – the amount that would be received if exercised immediately.
C. Out-of-the-Money
For call option, the strike price is ABOVE the current stock price, it is out-of-the-money. For example, ABC June $85 Call, where the current ABC stock price is $83, it is out-of-the-money by $2 ($85-$83).
For put option, the strike price is BELOW the current stock price, it is out-of-the-money. For example, ABC June $85 Put, where the current ABC stock price is $88, it is out-of-the-money by $3 ($88-$85).
Also, an option with no intrinsic value is used to be out-of-the-money.
2. Volatility
This portion of the option price is a representation of the historical and implied volatility in the stock market refers to the movement in the price of a security as a function of time.
For example: If a stock moves $1 in one day it is more volatile than a stock that moves $1 in one week. For the benefit of this higher relative volatility we must pay a higher price for the associated options.
3. Time Value
This is the cost of the time from the present to the date of expiration.
For example: The costs of a Wal-Mart May 45 call option will be more than the cost of a Wal-Mart March 45 call option.
In the example of the May 45 option, we will pay more for the benefit of having an added two months until expiration.
Think… why would this extra two months be worth paying for?
Consider the possibilities involved in the price changes in the underlying stock. Is it more likely that the underlying stock will move $1 in one month or three months than in one month?
We will then expect to pay a higher premium for the disadvantage of this added time.
OPEN INTEREST
“Open interest” refers to the numbers of outstanding contracts of a particular option. By knowing this number, we have a good indicator of the liquidity of the option.
Knowing the open interest of an option being considered for trade is critical!
So here is the rule concerning open interest:
Do not invest more than 10% of the open interest
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