Option Price vs. Stock Price
You've read about the definition of options
, you've learned about option selling strategies
. You've learned about the options market
, and now you want to know more about the relationship between the option and the underlying stock. Let's go over some final definitions and then move on to what actually determines the value of options.
other definitions Classes and Series:
The class of the option refers to all put and call contracts on the same underlying stock. For example, all Dell options- all puts and calls at various strike prices and expiration months- form one class. A series is a subset of a class, and it represents all contracts of the same class having the same expiration date and striking price.
Opening and Closing Contracts:
An opening transaction is the initial transaction, and is either a buy or sell order. A closing transaction diminishes or reverses the investor's position. Opening buys are usually followed by closing sales, while opening sales often precede closing buy orders.
: The option exchanges keep track of the amount of opening and closing transactions in each option series. Each opening transaction adds to the open interest, and each closing transaction diminishes the open interest. The open interest is expressed in the number of option contracts. This data is useful in determining the liquidity of the option, or stock for that matter.
Holder vs Writer:
The person who buys an option as an opening transaction is called the holder. The person who sells an option as an opening transaction is called the writer. The writer of the option is referred to as being short, while the holder is referred to as being long .
Exercise and Assignment:
When the holder invokes the right to buy or sell, it is considered as exercising the option. Whenever a holder exercises an option, a writer is assigned the obligation to sell, or if a put option is exercised, then the writer is assigned the obligation to buy.
Intrinsic Value vs. Time Value:
The intrinsic value is the difference between the underlying stock price and the exercise price. The time value is a premium allocated to the value of the option for its duration period. The total value of the option is the sum of the intrinsic value and the time value. Once it expires, the value of the option is only the intrinsic value.
Term used to explain that the option is neutral. This means the exercise price is equal to the underlying stock price for a call option, or that the exercise price is equal to the underlying stock price for a put option.
Term used to explain that the option is profitable. This means the exercise price is lower than the underlying stock price for a call option, or that the exercise price is higher than the underlying stock price for a put option.
Term used to explain that the option is not profitable. This means the exercise price is higher than the underlying stock price for a call option, or that the exercise price is lower than the underlying stock price for a put option.
An option's price is the result of properties that belong to both the underlying stock and the terms set out in the option. The major factors are:
The market price of the underlying stock:
If the stock price is far below or far above the striking price, the other factors have little influence. On expiration day, only the stock price and the striking price of the option determine the option's value. At this time, an option is worth only its intrinsic value.
Striking Price of the Option itself:
The closer the strike price is to the underlying stock price, the higher the value of the option, because your chances of making money are greater than if the strike price is far from the underlying price.
Time remaining until the expiration of the option:
The more time remaining until maturity, the higher the value of the option, because you have a longer period of time for the option to be in-the-money.
Volatility of the underlying stock:
High volatility means the stock's price fluctuates in high movements. More volatile underlying stocks have higher option prices because the large fluctuations increase the chance of the option being in-the-money.
The current risk-free interest rate (90 Treasury bills):
Higher interest rates imply slightly higher option premiums, while lower rates imply lower premiums.
I hope that I clarified options a little better for the average investor. As you can see, options are not that complicated. Anyone with half a brain can use options to increase the value of their portfolio. Now all you have to do is read up a little more on options, and soon you'll be buying your first Ferrari.