Stock and option trading has special value components that make up the premium. The premium is the determination of the option’s value and it is also the price at which the option was traded most recently.
You may think that stock and option trading bidders or traders bid on option contracts using the strike price. That is not true. A trader makes a bid on an option price and is actually bidding on the option premium. On the other side of the transaction, the trader makes an offer which is the premium price he or she is willing to sell the option at.
In stock option trading, when you bid on an option, you must have the amount of the premium in your trading account. At the end of each day, it is the premium value that is used to calculate account value for reporting your option position. This is an important concept to understand in stock and option trading because it is the foundation of the profit or loss calculation.
Intrinsic and Time Value of the Premium
Understanding what makes up the premium is very important to understanding what makes options tick. The stock and option trading premium has two major components.
Intrinsic Value
Intrinsic value applies to options that are in the money. In the money is a term that applies to options in which the price of the underlying asset is higher than the option strike price. Intrinsic value is the actual value related to the strike price and the futures price. This is the first value component in stock and option trading.
When a call option (right to buy or go long) has a strike price that is lower than the futures price, there is intrinsic value. For example, a stock has a futures market value of $20. An $18 call would mean there is $2 of intrinsic value in the premium.
A put option (right to sell or go short) has a strike price that is higher than the futures price. In another example, a stock with a futures market price of $20 and a $23 put then there is $3 intrinsic value.
Time Value
Time value, or risk value, is the extrinsic value of the stock option. It is the amount of premium that is above the intrinsic value. If the strike value equals the futures value, there is no intrinsic value so the entire premium is made up of time value only.
In other words, time value is the portion of the premium value that is related to the risk of selling the option. An option that is out of the money (futures price has not hit the strike price in direction of the option) or at the money does not have intrinsic value.
When stock and option trading, the longer the time left until the expiration date, the more risk there is of the market changing so time value is higher. The time value will decline the closer the option gets to the expiration date. This is referred to as time decay in stock and option trading.
In stock and option trading, the value of time and the concept of time decay are important to understand. Time value decay, as it concerns buying and selling options, is how you can measure the possible rate of premium loss.
Filed under All About Options by on Apr 2nd, 2011. Comment. 
A call put option is actually referring to a spread strategy used to manage risk when trading options. Vertical spreads is the simultaneous buying and selling of options at different strike prices and with different expiration dates. Two types of basic spreads are called the bull call spread and the bear put spread.
Running of the Bulls in a Call Put Option
The first call put option is called the bull call spread. The bull call spread is an options strategy that utilizes two actions. You purchase a call option at one strike price, and you sell the same number of call options for the same underlying asset and expiration date but at a higher strike price. The combination is called a spread because you spread the possibility of a profit between the strike prices.
The risk attached to the short call option is being offset by the possibility of profit being made on the purchased call option position. The maximum amount of profit you can make is the difference between the option strike prices less the net cost of the options.
The bull call spread lowers your risk of loss by combining the purchase of the call option premium with the sale of option premium. The sale of the option premium lowers costs. This call put option spread limits risk but you should understand it also limits the amount of profit you can make because of the short call position.
- Stock price is at $20
- Trader buys one call option with a $22 strike price
- Trader sells one call option with a strike price of $27
- Stock price increases to $32 per share
- Trader exercises call option at $22 per share price and
- Trader sells one call option at $27 per share price
If the trader had been required to buy the shares at $35 to fulfill the option contract, he or she would have had to sell them for a loss. This is the advantage of using the call put option.
When Bears Growl in a Call Put Option
When looking at the variety of call put option strategies, another basic one is the bear put spread. The bear put spread is the opposite of the bull call spread. It uses the same principles as the bull call spread. But in this strategy you are purchasing a put option with a higher strike price and then selling an equal number of put options at a lower strike price.
This strategy can lower the cost of a trade equating to higher profit and less trade risk. On the other hand, the profit potential is limited in this call put option.
Here is how this particular call put option strategy called the bear put spread works.
- Buy an option at a strike price of $45 on a stock that is selling for $46 per share
- Assume 60 days until option expiration
- Assume a premium of $2.00 so that the premium is $200
- Price of the stock falls to $40
- Buyer of put option exercises the put option and sells short 100 shares at $45
- Buyer then buys back the 100 shares at $40 per share
- Profit is the difference between the $45 per share and the $40 per share
Strategies using a call put option limit risk. The bull call spread and the bear put spread are just two strategies that options traders commonly use. They are easy to implement and track and that is one reason they are good spread strategies for beginner and advanced traders.
Filed under Option Trading Strategies by on Mar 25th, 2011. Comment.
Using both call and put options, you can hedge your investments and thus lower your risk of loss. The concept of hedging is important to understand if you want to minimize risk.
Hedging with Call Put Options Trading
Call put options trading refers to using both a call and a put to offset the risk of each investment. Hedging is one of the most important concepts you will learn when investing in stock options because it is a way to reduce your risk of loss by playing both sides of a market.
Though we always enter the stock options market with the intent of making a profit, there is always a risk of loss. Limiting that loss potential is integral to wise stock options investing. You will use hedging to wait out a short term unpredictable market or manage an expected weakness in the underlying stock.
There are a number of hedging strategies including:
- Covered put purchased against a stock you already own to protect your portfolio against an expected short term market decline
- Purchase of index puts against a stock you already own to defend against a general broad market fall
- Purchase of EFT puts against a stock you already own to defend against a general broad market fall
To protect against a market fall, you buy puts. To protect against a market rise, you would buy calls. Either way you are straddling the price line. Hedging is all about transferring the risk of owning a stock portfolio through options buying and selling. In other words, you let a price speculator assume some of the price movement risk. The index funds you would choose to option would be any that closely match the makeup of your stock portfolio.
Indexes to Consider
Each broad based index is a composite of stocks that represent a particular market or industry. Each one uses different criteria for evaluating performance. There are a number of broad based indexes in which you can buy options and hedge your risk against price changes in your current stock portfolio.
Following is just a sample of the types of indexes that exist.
- Nasdaq-100 Index (NDX)
- New York Composite Index
- Russell 2000 Index
- Over the Counter Index
- Russell 2000 Index
- AMEX Major Market Index
- Value Line Composite Index
- Wilshire 500 Index
- S&P 500 Index
There are also hundreds of indexes tied to particular market sectors like green energy, transportation, biotechnology and so on. The U.S. Securities and Exchange Commission at http://www.sec.gov/answers/indexf.htm provides an easy to understand explanation of index funds.
You can protect against a stock price increase by hedging with the purchase of calls. When stock prices rises, the value of the call will rise also.
Believing Stock Underperformance is on the Horizon
Using the concept of hedging can protect your stock portfolio from a price or market pullback. You may be expecting seasonal declines, anticipate bad news or have read that an industry downturn is predicted and decide you need to protect your stock portfolio. Hedging your risk by using covered puts or indexed puts can limit your loss.
You do need to understand though that if the stock price remains stable or even goes up, you will lose your premium after the options expire.
Call put options trading can give you some peace of mind when you believe the market is getting ready to decline. You can offset some of your losses in your stock portfolio or maximize profits when stock value increases.
Filed under Option Trading Strategies by on Mar 18th, 2011. Comment.