Regardless of the position a trader is opening, he/she has an assumption regarding the movement of a stock's price: up, down, or constant. When a trader assumes that a stock will go up or down, there are technical terms that can be used to describe this assumption.
Bullish: Bullish traders assume the stock's price will rise. Preliminary examples of trades with bullish assumptions include:
Bearish: Bearish traders assume the stock's price will fall. Preliminary examples of trades with bearish assumptions include:
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Buying Puts? No need to fear!
By buying a put option, the buyer can sell units of stock at the set strike price, when the current market value of the stock is lower than the strike price at or before expiration.
What does this mean?
When buying or selling any option there are three key elements: premiums, strike prices, and expirations-- this holds true for buying puts, just as it did for buying calls. When buying a call option the buyer must pay a premium, or a small fee, to the seller. This validates the options agreement between the two parties of the options contract. The buyer sets both a strike price and expiration, and is matched with a seller in the market who has set the same values for his/her transaction. The strike price, in the instance of the buying a call, is the maximum amount of money the buyer is willing to spend when purchasing units of stock. The expiration date, set by the buyer, is the period in which the contractual agreement between the buyer and the seller is upheld. (Fix...)
By paying a premium fee to the seller, the buyer of the call may sell the units of stock to the seller, if the price of the stock reaches or exceeds the set strike price within the time period/before expiration.
The probability of success with options is determined by the movement of the stock. For buying puts, if the stock's price...
Stock: UAL- United Airlines (Market Price: $53.50)
Volatility @ Sell: 49.83%
Volatility @ Buy: 42.00%
Volatility Contraction or "Crush": 7.83%
Expected Move: Midpoint of Bid-Ask Spread of Selling ATM Call: $.93 Midpoint of Bid-Ask Spread of Selling ATM Put: $1.40 Sum: $.93+$1.40= $2.33= Expected Move of stock's price
1. Sold call @ ATM Strike of $53.50 for premium of $.93 (To break even, the stock must not cross $53.50 + $.93. To profit, the stock must be below the break even price)
2. Sold put @ ATM Strike of $53.50 for premium of $1.40 (To break even, the stock must not go below $53.50-$1.40. To profit, the stock must be above the break even price)
3. Combined Both transactions were sold at ATM (at-the-money, or equal to current market price) strike prices. The premiums sold were the midpoints of the respective option's bid-ask spread. In order to profit, with the combined transaction, the stock's price must be above below the #1's break even price and above #2's break even price. This means I must be within +$.93 or -$1.40 of the ATM strike/current price. The total range of movement allotted for me to profit is $2.33.
As stated above, and not coincidentally, the expected move of a stock is determined by the sum of the midpoints between the bid-ask spread (mid-price fills) for selling ATM calls and put, or $2.33. The sum of the premiums (the midpoints) is the expected move and the range that I want to be in in order to profit!
The intrinsic and extrinsic value of puts and calls are similar. In cases of skew (to be explained in separate post), the puts can be priced higher than can calls in which case the extrinsic value of put is higher than the same for an equidistant call.
The formula remains pricing of Option = Intrinsic Value + Extrinsic Value
The intrinsic value is the absolute difference between the strike price and current stock price. Intrinsic value of a call only exists for ITM strikes (which in the case of puts are strikes above the current price) and is 0 for OTM strikes.
Extrinsic pricing follows the same methodology that it does with calls; extrinsic should be thought of as the extra incentive for offering an option to a buyer, and peaks at the current price, decreasing as the strike gets further ITM or OTM. Extrinsic is also called 'time value' or 'time premium'.
When you sell an option, it's the time value or the extrinsic that's decaying per day. Conversely, if you are buying an option, you need a movement of the stock to overcome the daily decay of the time value of the option you own.
Eighteen-year old trader, future connoisseur of options.
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