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Option is a legal agreement between buyer and seller to buy or sell security at an agreed price in a certain period of time. It is quite similar to insurance that you pay an amount of money in order that your property is protected by the insurance company. The difference between these two is option can be traded whereas, insurance policy cannot be traded. There are two types of option contracts; call options and put options. We buy call option when we expect the security price will go up and buy put option when we expect the security price will go down. We also can sell call option if we expect the security price will go down and vice versa if we sell put option.
Usually, option is counted by contract, one contract equivalent to 100 unit options. 1 unit option protects 1 unit share. So, one contract protects 100 unit shares. Before learning how to trade option, terminologies that you need to know are as follow: a) Strike price: Strike price is the price that is agreed by both buyer and seller of the option to deal with. That means if the strike price of the call option is 35, seller of this option obligates to sell security at this price to the buyer of this option even though the market price of the security is higher than 35 if the buyer exercises the option.
Buyer of this option can buy a security with a price that is lower than the market price. If the current market price is $39, the buyer will earn $4. If the security price is lower than the strike price, buyer will hold the option and leave the option to expire worthless. For put option strike price, buyer of the option has the right to sell the security at the strike price to the seller of the option. That means if the put option strike price is 30, seller of this option obligates to buy the security at this price from the buyer if he or she exercises the option even though the market price is lower than this price. If the market is $25, the option buyer will earn $5. It looks like a lot of transactions have been involved; but actually, seller of the option will not buy a security and sell it to the buyer. The broker firm will do all the transaction but the extra money that has used to buy the security has to be paid by the seller. This means, if the seller loss $4, the buyer will earn $4. b) Out of the money, in the money and near/at the money option: Option price comprises of time value and intrinsic price.
Time Value + Intrinsic Value = Option Price Time value is the amount of money that the option worth due to the time the option has until its expiration date. Longer the time the option has until its expiration date, higher the time value of this option. Time value of an option will become zero if the option has expired. Intrinsic value for in the money call option is the difference between current market security price and option strike price. Conversely, in the money put option’s intrinsic value is the difference between option strike price and current market security price. If the current security price is lower than the call option strike price, this option is an out of the money option. It only has time value. Call option with strike price that is lower than the current market security price is an in the money option. This option has time value and also intrinsic value. Near or at the money option is the option, which strike price is close to the current market security price.
c) Delta value: Delta value shows the amount of the option price will change when the security price changes by $1. It is a positive value for call option and negative value for put option. It ranges from 0.1 to 1. Delta value for in the money option is more than 0.5 and out of the money option is less than 0. Delta value for deep in the money option usually is more than 0.
If the option delta value is 0.6, meaning that when the security price goes up $1, option price will go up $0. If the security price goes up $0.10, the option price will goes up $0. Usually, $0.06 will round up to $0.
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