Before one can trade options one must understand the fundamentals of option pricing.
An error many beginning option traders make is thinking that options are only used to speculate on market movements. Actually, options first evolved as insurance products. One of the first documented uses of option contracts was in the 16th century by the Dutch. There was a wild craze for tulip bulbs which drove the prices of the bulbs to insane levels. People were selling their land to partake in the speculation. Once the prices reached all time highs people started to "insure" their purchases with put contacts. Both calls and puts can act like insurance products: a call can "insure" someone who is short stock against a rise in the price of the underlying security and a put can "insure" someone who is long a stock against a drop in the price of the underlying security. The understanding that modern options contracts evolved from insurance purposes is actually fundamental to explaining option prices.
To try to explain this concept further, let's look at what makes up a car insurance policy. There are five variables that actuaries use when trying to determine the premium to charge for a policy: the price of the asset, the deductible, the length of the policy, the cost of carry, and the risk of the driver. These same five variables you will find in option pricing models. One of the most well-known option pricing models is the Black/Scholes model. In order to calculate the price or premium of an option contract you must first input into the model the price of the underlying, the strike price of the option, the days to expiration, the risk-free interest rate and dividend information for the underlying, and the volatility of the underlying.
The underlying stock price is the same concept as the cost of the car. It will generally cost you more to insure a Volvo then it does to insure a Yugo. In the option marketplace, the options will cost you more on a $100 dollar stock then on a $10 stock.
If you are willing to take a larger deductible on your car insurance, the cost of the insurance will decrease. The deductible-equivalent in the options world is determined by the strike price of the option. If you're willing to buy an option with a strike price that is very out-of-the-money, that means you are willing to accept more risk -- hence the cost of the option drops to reflect this deductible. Time is money; a six month car insurance policy will cost less that a one year policy. In the option marketplace this is also true; a six month option contract will cost less than a one year option contract.
Cost of carry is something many people don't think about when they buy car insurance, but it is definitely a factor. When you purchase an insurance policy you pay for the policy at the beginning of the contract, which means the insurance company earns interest on those monies throughout the life of the policy. This concept is also true in the options marketplace. When you buy an option you pay for it right away, which means the seller of the contract can earn interest on your dollars. One thing that is a little different with options and stocks: if you are "insuring" a stock with an option, the stock will sometimes pay a dividend. Car companies do not pay dividends to the owner of the car. So in the options market place the models have to account for the possible dividend.
Now we come to the mysterious variable, risk. Actuaries try to use statistics to determine the risk of you getting in to an accident versus someone else getting into an accident. In the option marketplace the measure of risk is called volatility. Volatility is also based on statistics. The text book definition of volatility is the "annualized standard deviation of stock price movements". It is figured by looking at the high price and the low price each day over the past year and determining the distance between the two points. The wider the distance between the two points the more volatile the security is. The more volatile the security is the more costly the insurance or option contract on the security will be. The next blog will focus on what volatility is and why it is an important number for the option trader to understand.
Regards,
Brian (OG)
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility there is no guarantee the this forcast will be correct.
Buying Calls - Risks and rewards
Maximum Profit: Unlimited
Maximum Loss: Limited - Net Premium Paid
Upside Profit at Expiration: Stock Price - Strike Price - Premium Paid.
Assuming Stock Price above break-even point. Your maximum profit depends only on the potential price increase of the underlying security; in theory it is unlimited. At expiration an in-the-money call will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premium initially paid for the call. Whatever your motivation for purchasing the call, weigh the potential reward against the potential loss of the entire premium paid.
Buying Puts - Risk and rewards
Maximum Profit: Limited Only by Stock Declining to Zero
Maximum Loss: Limited- Premium Paid
Upside Profit at Expiration: Strike Price - Stock Price at Expiration - Premium Paid
Assuming Stock Price Below break-even point. The maximum profit amount can be limited by the stock's potential decrease to no less than zero. At expiration an in-the-money put will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premium initially paid for the put. Whatever your motivation for purchasing the put, weigh the potential reward against the potential loss of the entire premium paid.
