Part 12 Trading Master Class With ExpertsI. Introduction to Options
What is an Option?
An option is a financial derivative contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) within a specified time period. Options derive their value from the underlying asset, which can be stocks, indices, commodities, currencies, or ETFs.
Types of Options
There are two primary types:
Call Option: Gives the holder the right to buy the underlying asset at a strike price before expiration.
Put Option: Gives the holder the right to sell the underlying asset at a strike price before expiration.
Buyers vs. Sellers
Option Buyer (Holder): Pays a premium for the right to exercise the option. Limited risk (premium paid), unlimited or capped potential reward depending on call or put.
Option Seller (Writer): Receives the premium. Obligated to fulfill the contract if exercised. Higher risk, especially in uncovered options.
Option Premium Explained
The premium is the price paid for the option. It comprises two components:
Intrinsic Value: The real, immediate profit if exercised now (for in-the-money options).
Time Value: Additional value based on time left until expiration and market volatility.
Option Expiration and Exercise
Options have a fixed expiration date. Exercise can happen in two ways:
American Style: Can be exercised any time before expiration.
European Style: Can only be exercised at expiration.
II. Understanding Option Pricing
Factors Affecting Option Pricing
The price of an option (premium) is influenced by:
Underlying asset price
Strike price
Time to expiration
Volatility
Interest rates
Dividends
Intrinsic vs. Extrinsic Value
Intrinsic Value: Difference between underlying asset price and strike price (only if in-the-money).
Extrinsic Value: Time value and volatility premium. Represents potential for future gains.
Moneyness of Options
Options are classified based on their intrinsic value:
In-the-Money (ITM): Profitable if exercised now.
At-the-Money (ATM): Strike price equals the underlying asset price.
Out-of-the-Money (OTM): Not profitable if exercised now.
The Greeks – Risk and Sensitivity Measures
Options are influenced by “Greeks” which measure sensitivity to different factors:
Delta: Sensitivity of option price to underlying asset price change.
Gamma: Rate of change of delta.
Theta: Time decay of option value.
Vega: Sensitivity to volatility.
Rho: Sensitivity to interest rates.
Black-Scholes & Binomial Models
Option pricing models estimate theoretical values:
Black-Scholes Model: For European options; factors in price, strike, volatility, time, and risk-free rate.
Binomial Model: Uses a stepwise approach; suitable for American options.
