Just as investors were advised prior to the recent kerfuffle to take profits on stocks and replace winning positions with bullish calls, it is time to play the other side. See below an excerpt from my Options for Beginners course where I introduce the concept of time decay:.
Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibilities of substantial moves both up and down.
Greater price swings will increase the chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way. Let's say that on May 1, the stock price of Cory's Tequila Co. You could sell your call option, which is called "closing your position," and take your profits — unless, of course, you think the stock price will continue to rise.
For the sake of this example, let's say we let it ride. So far, we've talked about the option holder having the right to buy or sell exercise the underlying stock. While this is technically true, a majority of options are never exercised. You could also keep the stock, knowing you were able to buy it at a discount to the present value.
However, the majority of the time, holders choose to take their profits by trading out closing out their position. This means that option holders sell their options in the market, and writers buy their positions back to close.
Now is a good time to dig deeper into pricing options. Time value represents the added value an investor has to pay for an option above the intrinsic value. So, the price of the option in our example can be thought of as the following:.
A brief word on options pricing. The market assigns a value to an option based on the likely outcome relative to the underlying asset, as in the example above. But in order to put an absolute price on an option, a pricing model must be used. Since then, other models have emerged, such as binomial and trinomial tree models, which are commonly used by professional options traders.
In real life, options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely. Call and Put Options Options Basics: How Options Work Options Basics: Types of Options Options Basics: Options Spreads Options Basics: Options Risks Options Basics: See below an excerpt from my Options for Beginners course where I introduce the concept of time decay: Are you sure you want to change your settings?
Bid "Bid" is the price a potential buyer is willing to pay for a security. Sometimes also used in the contect of takeovers where one corporation is bidding for trying to buy another corporation.
In trading, we have the bid-ask spread which is the difference between what buyers are willing to pay and what sellers are asking for in terms of price. Ask "Ask" is the quoted ask, or the lowest price an investor will accept to sell a stock. Practically speaking, this is the quoted offer at which an investor can buy shares of stock; also called the offer price. Vol "Volume" is the daily number of shares of a security that change hands between a buyer and a seller.
Also known as volume traded. Open Int "Open Interest" is the total number of derivatives contracts traded that have not yet been liquidated either by an offsetting derivative transaction or by delivery. Root Strike "Strike" is the index value at which the buyer of the option can buy or sell the underlying stock index. The strike index is converted to a dollar value by multiplying by the option's contract multiple.
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