The more likely something is to occur, the more expensive an option would be that profits from that event. This is the key to understanding the relative value of options. Likewise, the same option that expires in a year will cost more. This is also why options experience time decay: Thus, as the price of the underlying asset rises, the price of the call option premium will also rise.
Alternatively, as the price goes down — and the gap between the strike price and the underlying asset prices widens — the option will cost less. There is one other factor that can increase the odds that the event we want to happen will occur — if the volatility of the underlying asset increases.
Something that has greater price swings — both up and down — will increase the chances of an event happening. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way.
Let's say that on May 1, the stock price of Cory's Tequila Co. In reality, you'd also have to take commissions into account, but we'll ignore them for this example. You almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and take your profits — unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride. So far we've talked about options as the right to buy or sell exercise the underlying good.
This is true, but in reality, a majority of options are not actually exercised. You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time holders choose to take their profits by trading out closing out their position.
This means that holders sell their options in the market, and writers buy their positions back to close. At this point it is worth explaining more about the pricing of options. These fluctuations can be explained by intrinsic value and extrinsic value , also known as time value. Intrinsic value is the amount in-the-money , which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value.
Refer back to the beginning of this section of the turorial: This is the extrinsic, or time value. So, the price of the option in our example can be thought of as the following:.
In real life options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely. If you are wondering, we just picked the numbers for this example out of the air to demonstrate how options work. A brief word on options pricing. But in order to put an absolute price on an option, a pricing model must be used.
Since then other models have emerged such as binomial and trinomial tree models, which are also commonly used. Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.
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Become a day trader. How Options Work Options Basics: Types Of Options Options Basics: Options Spreads Options Basics: Options Risks Options Basics: The price of an option, otherwise known as the premium, has two basic components: Understanding these factors better can help the trader discern which Options can be an excellent addition to a portfolio.
Find out how to get started. Take advantage of stock movements by getting to know these derivatives. Trading options is not easy and should only be done under the guidance of a professional. Learning to understand the language of options chains will help you become a more informed trader. The adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably.
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