Basic Options Part III Option Pricing
ETF Trend Trading Option Basics Part Three Pricing and Options Premium
Option Basics • Separate Sections 1. Option Basics 2. The Greeks
3. Pricing & Options Premium 4. Types of Option Trades
Option Premium • Six Major Factors that Influence Option Premium 1. A change in the price of an underlying 2. Strike Price 3. Time Until Expiration 4. Volatility 5. Dividends 6. Interest Rate
Option Premium 1. A change in the price of the underlying • Can Increase or decrease the value of an option (The price changes have the opposite effect on calls and put) • •
In general, the value of a call will increase as the price of the underlying increases ( a put will decrease n value) In general, the value of a put will increase as the price of the underlying decreases ( a call will decrease in value)
Option Premium 2. Strike Price • Determines if an option is ITM, ATM or OTM • Determines whether or not an option has any Intrinsic Value • An options value increases as the option becomes further ITM • An options value decreases as the option becomes further OTM
Option Premium 3. Time Until Expiration • In General - The more time remaining until expiration the higher the time (extrinsic) value of the option will be • As expiration approaches the time value decreases or erodes ( true for both calls and puts) • The “erosion” is most noticeable for ATM options
Option Premium 4. Volatility • The most subjective and most difficult factor to quantify • Can have significant impact on the time value of the option !!!!!!! • A measure of risk or uncertainty in the underlying price of the security • The higher the volatility the greater the expected flucuations in the underlyings price
Option Premium 4. Volatility (Continued) • The higher the volatility the higher the premium will be • This is similar for in nature for both calls and puts • Volatility impacts ATM options the most
Option Premium 5 & 6. Dividends and Interest Rate • Have a limited / small effect on options pricing
Pricing / Options Premium The premium (Value) of an option has 2 main components 1. Intrinsic Value 2. Extrinsic Value or “time value”
The Value of an option = Intrinsic Value + Extrinsic Value
Intrinsic Value Intrinsic Value of a call
Intrinsic Value Intrinsic Value of a Put
Option Basics In The Money vs. Out of The Money
In the Money
Out of the Money
Call
A Call Option is In The Money (ITM) if the current market value of the underlying is above the exercise (strike) price of the option
A Call Option is Out of The Money (OTM) if the current market value of the underlying is below the exercise (strike) price of the option
Put
A Put Option is In The Money (ITM) if the current market value of the underlying is below the exercise (strike) price of the option
A Put Option is Out of The Money (OTM) if the current market value of the underlying is above the exercise (strike) price of the option
Intrinsic Value of Options OTM
Calls
Puts
No Intrinsic Value
Intrinsic Value = Strike Price – Current Stock Price
ITM
Zero
ATM
Strike Prices
ATM
Zero
Strike Prices
Strike Prices
ITM Strike Prices
Intrinsic Value = Current Stock Price Strike Price
No Intrinsic Value
OTM Strike Prices
Extrinsic Value Extrinsic Value = Time Value
The longer the amount of time to expiration the greater the time value
Option Price / Value
Option Price
Option Basics • Separate Sections 1. Option Basics 2. The Greeks
3. Pricing & Options Premium 4. Types of Option Trades
Option Premium • Six Major Factors that Influence Option Premium 1. A change in the price of an underlying 2. Strike Price 3. Time Until Expiration 4. Volatility 5. Dividends 6. Interest Rate
Option Premium 1. A change in the price of the underlying • Can Increase or decrease the value of an option (The price changes have the opposite effect on calls and put) • •
In general, the value of a call will increase as the price of the underlying increases ( a put will decrease n value) In general, the value of a put will increase as the price of the underlying decreases ( a call will decrease in value)
Option Premium 2. Strike Price • Determines if an option is ITM, ATM or OTM • Determines whether or not an option has any Intrinsic Value • An options value increases as the option becomes further ITM • An options value decreases as the option becomes further OTM
Option Premium 3. Time Until Expiration • In General - The more time remaining until expiration the higher the time (extrinsic) value of the option will be • As expiration approaches the time value decreases or erodes ( true for both calls and puts) • The “erosion” is most noticeable for ATM options
Option Premium 4. Volatility • The most subjective and most difficult factor to quantify • Can have significant impact on the time value of the option !!!!!!! • A measure of risk or uncertainty in the underlying price of the security • The higher the volatility the greater the expected flucuations in the underlyings price
Option Premium 4. Volatility (Continued) • The higher the volatility the higher the premium will be • This is similar for in nature for both calls and puts • Volatility impacts ATM options the most
Option Premium 5 & 6. Dividends and Interest Rate • Have a limited / small effect on options pricing
Pricing / Options Premium The premium (Value) of an option has 2 main components 1. Intrinsic Value 2. Extrinsic Value or “time value”
The Value of an option = Intrinsic Value + Extrinsic Value
Intrinsic Value Intrinsic Value of a call
Intrinsic Value Intrinsic Value of a Put
Option Basics In The Money vs. Out of The Money
In the Money
Out of the Money
Call
A Call Option is In The Money (ITM) if the current market value of the underlying is above the exercise (strike) price of the option
A Call Option is Out of The Money (OTM) if the current market value of the underlying is below the exercise (strike) price of the option
Put
A Put Option is In The Money (ITM) if the current market value of the underlying is below the exercise (strike) price of the option
A Put Option is Out of The Money (OTM) if the current market value of the underlying is above the exercise (strike) price of the option
Intrinsic Value of Options OTM
Calls
Puts
No Intrinsic Value
Intrinsic Value = Strike Price – Current Stock Price
ITM
Zero
ATM
Strike Prices
ATM
Zero
Strike Prices
Strike Prices
ITM Strike Prices
Intrinsic Value = Current Stock Price Strike Price
No Intrinsic Value
OTM Strike Prices
Extrinsic Value Extrinsic Value = Time Value
The longer the amount of time to expiration the greater the time value
Option Price / Value
Option Price
