Further Options Basics

A notch or two above options basics…

There are so many sites on Options 101 that we shall here assume absolute options basics are covered.  Please take a look at the sites in the Recommended Reading section if you do not feel comfortable with the level here.

A bit of history… Options were a bit of mystery until a fairly accurate model came about in the seventies as a lateral thinking epiphany from two great physicists.  In a way, one could say it also opened a new research field for scientists in general who are now called Quants in the financial sector.  Basically, options are all about determining probabilities of being in the money (ITM) or not, and this is why the Greeks are so important as they measure the sensitivity of key parameters i.e. figure out the most accurate premium for a Call or Put option (both are obviously interlinked).

You are lost already ? Check the Recommended Reading page, and spend some time on YouTube for introduction tutorials.  Feel free to contact us to better assess if you are at the minimum prerequisite level to make the best of OM’s options trading coaching.  Mentoring classes are available to get you there.

Let’s now get on with it.  Before delving into the Greeks, let’s have a look at the option premium, made of its intrinsic and extrinsic value that is simply the time value or the option.  By definition, the only options that have intrinsic value are those that are in-the-money.

Intrinsic Value + Extrinsic Value = Total Option Value in other words:

Option Premium = Intrinsic Value + Time Value

Intrinsic Value (Call) = Underlying Price – Strike Price
Intrinsic Value (Put) = Strike Price – Underlying Price

The picture below shows an example with Calls and Puts either In-The-Money or Out-The-Money.  Clearly the intrinsic value evaluates the chances (or probabilities) for an option to be In The Money.

Intrinsic vs. Extrinsic value
Intrinsic vs. Extrinsic value

Of all options pricing parameters, Implied Volatility (or IV) is maybe the most elusive one.  As the name suggests IV is the volatility implied by the price of the option when all the other factors impacting on the options price are known, namely, stock price, strike price, time to expiry, interest rate and eventually dividends.  It is calculated as the expected annualised standard deviation of prices, always compared to standard (SV) or historical volatility (HV).  Most traders look at where the IV/SV ratio stands prior to determining the best strategy.  In OM’s case, it may be a situation to enter now or not as capturing optimal premium is obviously essential.

The most popular model for determining option prices and implied volatility is the Black and Scholes model – and most of the time this gives a good estimate of option price and implied volatility although academics argue that there are other more correct models.  The B&S pricing model is a closed equation, meaning that there is always a missing parameter namely IV to properly calculate the price of an option, hence empirical or market value is intertwined with its theoretical evaluation.  The equation below can certainly appear overwhelming.  Not to worry: for our trading method, only Greeks and IV do matter, assuming of course that the options analysis (or broker) platform does calculate them properly.

black scholes

Option premiums can be considered to be insurance for shares.  The greater the perceived risk about a share, the greater the insurance or option premium and therefore the greater the future volatility implied by the option price.  In some cultures where market speculation is a “dirty word”, one can summarise options as a way to buy or sell an insurance against an adverse behaviour of the underlying instrument.  This can lead to complex combinations to hedge the underlying, which we shall not cover here.  Traders following the Options Masters method only take part in this insurance business without any position on the underlying at all.

To go further, please take a look at the “Recommended Reading” page where links shall be provided (OM will try and update that page regularly).   It would pointless to plagiarise and unfair to copy/paste from so many good sites on options.  For the more mathematically inclined, there is an excellent book from John Hull called “OPTIONS, FUTURES, AND OTHER DERIVATIVES” (currently in its eighth edition).

As always, contact us at any time for a free assessment and plan forward

HTML Snippets Powered By :