|
First, let’s review some previously discussed options terminology: Options, by definition, give buyers the “option” or right to buy or sell an underlying futures contract—but not the obligation. A call option gives the buyer the right to go long (buy) the underlying futures market at a stated price (“the strike price”), anytime prior to option expiration. And a put op-tion gives the buyer the right to go short (sell) the underlying futures market at the strike price, anytime prior to option expiration.In addition to the type of option (put or call) and the current price of the underlying financial instrument, options premium pricing can be affected by the underlying futures market’s relation to:Time value. This is the portion of the option premium attributable to the amount of time remaining until the expiration of the option contract. In general, the longer the amount of time until an option’s expiration, the greater the time value.Volatility. This is the amount of price movement in the underlying market over time. Prices that experi-ence large swings up and/or down mean greater risk and potential reward—and therefore also mean a higher price on the option. Strike price. Also called the “exercise price,” this is the price at which the futures contract underlying a call can be exercised—and it is considered the biggest factor in determining the price of an option. Call options with a strike price below the current price of underlying futures contracts are said to have intrinsic value. Put options with a strike price above the current price of the underlying futures contract also have intrinsic value. Intrinsic value is the difference between the un-derlying stock’s price and the strike price—or the in-the-money portion of the option’s premium. So if a call options strike price is $25 and the underlying stock’s market price is at $35, then the intrinsic value of the call option is $10. For a better understanding of intrinsic value, traders should look at what it means to be in the money, at the money, and out of the money. In the money. The Great Depression era song, “We’re in the Money” is rumored to be a referral to this term, which means that options have achieved strike price. A call option is in the money if the strike price is below the price of the underlying futures. A put option is in the money if the strike price is above the price of the underlying futures. In-the-money options have positive intrinsic and time value.At the money. An option is at the money if the strike price is at the same price as the underlying futures, and only has time value—no intrinsic value.Out of the money. Out of the money means an option would basically be worthless if it expired on the day in question. A call option is out of the money if the strike price is above the price of the underlying futures. A put option is out of the money if the strike price is below the price of the underlying futures. Out-of-the-money options also have no intrinsic value.Options traders also look at the break-even point in their trading. Break even is the price at which an option’s cost is equal to the proceeds acquired by exercising the option. For both the buyer and writer of a call, the break even is the same. And if the futures price is above break even, it means a profit for the buyer of the call option and a loss for the writer of the call option:Strike Price + Premium + Commission and Fees = Break EvenFor both the buyer and writer of a put, the break-even point is also the same. And if the futures price is below break even, it means a profit for the buyer of a put option and a loss for the writer of the put option.
|
