Part 9 Trading Master ClassHow Options Work in Practice
Option buyers have limited risk (premium paid) but unlimited profit potential (in calls if stock rises, in puts if stock falls).
Option sellers have limited profit (premium received) but potentially unlimited risk.
This asymmetric payoff structure creates a market where traders, hedgers, and institutions interact.
Key Concepts
Intrinsic Value: Real profit if exercised immediately.
Time Value: Premium paid for potential future movement.
In-the-Money (ITM): Option already profitable if exercised.
Out-of-the-Money (OTM): Option has no intrinsic value, only time value.
At-the-Money (ATM): Strike = current market price.
Why Traders Use Options
Hedging – Protect portfolio against price swings.
Speculation – Bet on future price movements with smaller capital.
Income Generation – Sell options and earn premiums.
Arbitrage – Exploit mispricing between spot and derivatives.
Options Pricing Models
Two main models:
Black-Scholes Model: Uses volatility, strike, expiry, and interest rates to price options.
Binomial Model: Breaks time into steps, considering probability of price moves.
Factors affecting option prices:
Spot price of underlying
Strike price
Time to expiry
Volatility
Interest rates
Dividends
