Introduction to options
An option is merely a contract that gives you the right, but not necessarily the obligation, to buy an underlying stock at a certain price on a certain date. Options are merely contracts and generally control one hundred shares of the underlying stock.
Option prices are different than their underlying prices because they have a time element to them. If you don’t exercise, or sell an option, by the time the expiration date comes about you lose your money. Although there are ways to keep that from happening, it does create what’s called time decay. Options are a little different because of this time decay, as well as other things that influence time and price for options.
Expiration decay, or theta decay, volatility and other options Greeks is what makes options price a little differently than their underlying stock. Expiration date, or the time decay is one of the Greeks and is called theta. Volatility, or the amount the underlying stock moves in a given period of time is what makes pricing of options more difficult to understand than their underlying stocks. If a stock goes up and down you can just merely look at the price, but if an options price goes up and down it usually has something to do with the volatility of the underlying, as well. Therefore, you have to pay attention to the expiration date, volatility and a couple of other Greeks that we will discuss later.
Options are priced using a modeling method of one sort or another. One of the most common is the Black-Scholes pricing formula, or model. There are other pricing models and all give you roughly the same price as an estimate of what the fair value of an option should be. But what really tells you the value of an option is the market itself!
Options are priced very well these days; the market is very efficient. The market on most mainstream options are penny wide and have one dollar strike prices. This gives the retail investor a lot of control over what to buy and when and how to profit.
Trading options profitibaly is not as easy as buying a call then watch the market go up or to buy a used to and watch the market go down. Because we talked about volatility, it has a lot to do with the options pricing and whether you profit or lose on a trade. It is somewhat counterintuitive, similar to driving a jet boat. Sometimes, we are conditioned to use the brakes to slow down or make a turn like you would in a car, when really we should be pressing on the gas to turn, when driving a jet boat. Options are very similar in that sometimes what you really need to do seems counter intuitive. Most beginning options traders think that buying a call option when their bullish on a stock will make them money. But in its simplest form, as a stock goes up the options price actually goes down slightly because of the lower volatility. The intrinsic value, or the value that that option has in relation to the price of the underlying stock does go up, however, it is not usually enough to offset the volatility depletion or the time decay in an options price.
That’s why we teach about selling options. We may buy options to hedge against short options, but in general terms we sell options to benefit from the data decay, or positive theta. That’s how we named the website, selling theta, or selltheta.com represents positive theta, or time decay. Meaning you profit from time passing.
One trade where we may by a long option spread is called the calendar spread. The calendar spread is simply selling the front month option and buying an option further out in time at the same strike price as the front month option. We’ll explain more about calendar spreads in future stories.
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