Like the old expression that says you can’t walk before you crawl, you shouldn’t get involved in options trading until you know the option basics. In fact, let’s get very basic and review why option trading is a desirable investment opportunity. Following are some option basics to keep in mind:
- Protect your stock portfolio or other underlying assets from price changes
- Can choose to be a conservative or a speculative trader
- Enables you to deal with unexpected market changes or volatile markets
- Offers a way to invest in both bull and bear markets
- Able to leverage your investments
- Choice of strategies from simple to complex
Of course, every financial investment entails risk. That’s why you must spend the required amount of time understanding the fundamentals or option basics before investing. But with those fundamentals you can then begin to learn ever increasingly complex strategies that give you even more versatility.
Basics of Option Basics
All stories should start at the beginning, so the option basics you should begin with are the definitions of terms that pervade all options trading.
Option Definition – An option is a right, but not an obligation, to buy or sell and underlying asset at a specific price and on or by a stated expiration date.
Call Option – A call options is the right, but not the obligation, to purchase an underlying futures contract at a specified price at a specified time.
Put Option – A put option is the right, but not the obligation, to sell an underlying futures contract at a specified price at a specified time.
Option Premium – The premium is the price you pay for the option. It represents the maximum risk you experience when you don’t exercise the option.
Strike Price – The predetermined price in the options contract at which the underlying asset is bought or sold.
At the Money – An option is at the money when the strike price is close or equal to the current futures price.
In the Money – An option is in the money when the strike price is less than the market price of the underlying security.
Out of the Money – The call option is out of the money when the strike price is higher than the market price of the underlying security. Puts are out of the money if the strike price is less than the market price of the underlying security.
Delta – A measure of the effect of change in the price of the underlying asset on the option’s premium. It represents the amount of the change in the price of an option for each move in the price of the underlying asset equal to one point.
Volatility – A measure of how fast and by how much prices of the underlying asset change. It is a measure of the rate of price fluctuations.
Get Comfortable with the Option Basics
It is important to get comfortable with the option basics before you make your first trade. The terms are used by traders and are imbedded in the charts that report options trading prices and activity. The option basics described above are just a few of the most fundamental.
Filed under Option Basics by on Mar 4th, 2011. Comment. 
The following factors affect the value of an option:
- Spot price of the underlying asset
- Strike price of the option
- Time to the expiration date of the option
- Risk-free interest rate
- Volatility of the underlying asset
- Option Pricing Model
The following option pricing models are often used to evaluate the fair value of the options:
- The Binomial model
- The black & Scholes model
Filed under All About Options, Option Basics by on Apr 16th, 2010.
The competitive bids and offers in the marketplace affect the option premium. The price of an option is a function of supply and demand. Stronger demand will drive the option price up.
An option premium is made up of two separate components:
- Intrinsic value: Intrinsic value of an option is based on the difference between its exercise price and the current price of the underlying asset. Intrinsic value is part of the premium which could be realized if the option were exercised. A put option has an intrinsic value only if the asset price is above the exercise price. A put option has an intrinsic value only if the asset price is below the exercise price.
- Time value: Time value represents the value placed on the possibility that the option may become profitable to exercise at some time before the expiry date. The entire premium of at-the-money options and out-of-the-money options represent time value. In-the-money options have time value in addition to intrinsic value. Time value declines over time as an option nears expiry. Expired option has zero time value. Hence the longer the time until the expiration date, the higher an option’s time value premium.
Factors that Affect the Value of an Option
The following factors affect the time value of an option:
Price of the Underlying Asset
The price of the underlying asset is the most important factor in determining the option premium.
Exercise Price of the Option
The premium for an option which is deeply out-of-the-money will be less than an option which is slightly out-of-the-money.
Time to Expiry
All other thing beings equal, the greater the time to the expiry date, the higher the time value of the option. Expired option has zero time value.
Market Volatility
The volatility of the underlying asset plays an important role in the valuation of an option. In general, the more volatile the market, the higher will be the premiums for option in that market.
Interest Rates
If there is a high cost of holding the asset due to high interest rates, there will be more demand for call options on that asset. This is because the purchase of an call option involves a far smaller cash outlay than buying the asset outright.
Cash Dividends
Any monetary return earned by holding the underlying asset will have effect on the price of an option. For example, dividends of an equity stock.
Filed under All About Options, Option Basics by on Apr 16th, 2010.