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.
As discussed in the "Expected Move" post, the expected movement of a stock can be calculated with the following formula, where S subscript 0 is the stock's current price, IV is implied volatility, and the final term is the square root of days to expiration divided by 365:
Though an intimidating formula at first glance, it provides traders with the approximate range in which a stock's price may travel in a given amount of time or days to expiration (DTE). Note: The image above should say plus or minus preceding the square root sign.
To visualize, let's look at an example. Assume a SPY stock's price on low for the year on Feb 11th 2016 as $182.86, with an implied volatility of 28.14%. To calculate the expected move in 30 days, we substitute "DTE" with actual number of dates and solve for EM.
The plus or minus range for each expiration will approximately equate to the EM calculations using the mid-price fills of EM spreads and the MMM value.
. The expected movement of a stock's price can be computed/deduced in several different ways. Some of my 'go to' techniques are:
(a) Use the price of the front month (week) straddle. Here we check the price of selling the ATM call and ATM put. The expected movement of a stock's price when using a straddle strategy is the sum of the mid-price fills between the bid-ask spread for selling ATM calls and put.
Example: Say the ATM call has a bid/ask spread of $1.10 and $1.20, we can assume the mid-price fill of $1.15 similarly, say the ATM put has a bid/ask spread of $1.40 and $1.50, we can assume the mid-price fill of $1.45 So the straddle would cost $1.15 + $1.45 = $2.60 This would imply an expected move of $2.60 from the current price. Most seasoned traders will consider 80% of this straddle price ($2.60 x 80% = $2.08) as the expected move, I'd like to be a bit more conservative in my trading.
(b) Use of MMM (on ThinkOrSwim platform) MMM is the Market Maker Move displayed on the 'Trade' tab of the ThinkOrSwim platform. It's the expected move as computed by the platform.
(c) Use of expected move formula: Expected Move = Stock price x IV x Square Root (Days to Expiration/365.25)
(d) Use of option greeks: We look at delta to deduce the 1 Standard Deviation move in the front month. We'll look at the strike price of the options with 16 delta which equates to 68.2% probability of falling in the money or 30 delta which equates to 50% probability of falling in the money. By using these strike prices, we are deducing the probability of success.
Every quarter, most publicly traded companies release earnings reports to inform shareholders of their sales, profits, outlook for next quarter etc. Upon and preceding the release of these reports, fear strikes in the market. When fear is high, a stock's price is considered volatile and there is inflated implied volatility (IV) in the derivatives/options market. Increased implied volatility corresponds to increased option prices, allowing traders, who are typically premium sellers, to open short positions. Post earnings announcement the implied volatility collapses and the options price kind of 'normalizes'.
To get a sense of this heightened IV prior to earnings, you can look at the options chain. The options chain closest to the earnings date (front month/week) will display an very high IV when compared to the other options chains going out farther in time (back month/week). Say if the front week is displaying an IV of 25% and the back week is displaying an IV of 20%, we can infer that post earnings announcement, the IV of the front week will collapse by about 5%. This 5% volatility crush to is the volatility contraction that the premium sellers are counting on to profit off of. The greater the volatility contraction, or "crush", percentage, the greater traders with short position profit.
When first discussing options, we noted that options were derived from a stock's price. What does this mean? Today we'll how option prices are derived for calls.
This is by no means a mathematically discussion on the options pricing model using Black Sholes or using advanced calculus or statistics, but a very basic way one would do business taking into account elements like risks and time.
Say I owned a house for $100K and you agree that the fair market value of the house today is $100K we could potentially do a deal where you'd pay me $100K and I'd sell you the house - today. But say, if you tell me that you don't have $100K today and would like to buy it from me say 30 days from now when you'd have that $100K, it would be only fair for me to charge you a small premium of say $1K to give you the right to buy the house at $100K 30 days from now. This would share the risk for both parties to an extent that the house could be worth $105K from now and you could benefit from this up move as you had purchased the right to buy this house by paying me $1K. Also, if the price of the house falls to say $95K in 30 days, my potential loss would have been mitigate by that small token $1K you'd have paid me, given that I doubt you'd still like to buy the house at $100K as market's moved down a bit.
So basically at the most fundamental level, options price the time value of the asset given various other market conditions (how far in time, the prevaling interest rates, fear of price movement etc)
Check example of few call options
In the above image, the current price of the stock is $108.48.
An option's price is calculated as follows: Option Price= Intrinsic + Extrinsic
For ITM calls, or calls with strike prices below the current price, the intrinsic value of the option is the current price minus the strike price. Why? Look back at our real world example; the minimum price that would be charged for buying an item at a later date for a lower price than is currently being asked would at least be the difference between the bid and ask prices for the good. Apply this mentality to calls, and the intrinsic value of the option price is derived. Why is the intrinsic price of the option $0 after $108.48 or the current stock price? After the strike price is ATM or OTM, there is no intrinsic value the seller assumes. In our real world example, if our customer would like to purchase the good for more than the current price being asked, why would be charge him/her an intrinsic price? ATM and OTM, the formula renders inapplicable as the result of the formula would provide negative intrinsic values.
For calls and puts, the extrinsic value of option is correlated to both time and risk. For the above image, the options chain is for a DTE of five days. For the respective prices, the extrinsic value or time premium is related to this expiration value. The extrinsic value is highest at ATM strikes, and decreases the further ITM or OTM the strike goes. Also, as the DTE increases, the extrinsic value increases as well, as the seller assumes more risk:
At-the-money, In-the-money, Out-of-the-money or ATM, ITM, and OTM. These will be terms, used to describe the strike price of an options position, that will be imperative to the understanding of derivatives.
Both calls and puts with ATM strikes have strike prices that are equal to the current price.
Calls with ITM strikes have strike prices that are less than the current price.
Puts with ITM strikes have strike prices that are greater than the current price.
Calls with OTM strikes have strike prices that are greater than the current price.
Puts with OTM strikes have strike prices that are less than the current price.
We’ve learned about stocks, so now let’s transition to options!
What’s an option?
An option is a type of derivative that gives the buyer of the option the right to buy or sell one hundred shares of stock at a given price (known as the strike) for a given amount of time until expiration. In layman’s terms, it is in sorts a hedge that buyer/seller is insured against price fluctuations in the market for a certain amount of time.
Why is an option a derivative?
Most liquid stocks have a corresponding option contract. The price of the option is primarily driven or derived by the price of the stock, but other factors like strike price, time duration, implied volatility, and prevailing interest rates, for example, play a significant role in deciding the theoretical price determination of an option.
What do I do with an option?
Well, there are many options. (Pun intended) There are two types of options: call options and put options. Just as you can buy and sell stocks, you can buy and sell options. These operations can be combined, and will be discussed in future strategies, but for today let’s break down the mechanics of buying a call option.
By buying a call option, the buyer can purchase units of stock at the set strike price, when the current market value of the stock is greater 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. 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 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.
By paying a premium fee to the seller, the buyer of the call may buy the units of stock from 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 calls, if the stock's price...
Ninteen year-old trader, future connoisseur of options.
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