Online Option Trading - Trade for a living, invest for life

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**Options Value:** Now that we understand the basic terminology of equity
**options** and how to read and understand an
online option chain, we are
now going to look at all the elements which influence the
trading value
of an **option**, and how to interpret this information in order to
asses the true value, or otherwise, of the option to you as a
trader.

Some of the terms may seem very odd, but again you will need
to understand them if you are to trade **options** successfully, and
follow all the **trading** strategies that options can provide to
the online trader.

**Option** buyers and sellers are really only interested in one
thing - the price of the option, in other words the premium, so
how is this **value** arrived at, and more importantly what can it
tell you about the possibilities for you as a trader. Let's
start with some basic terminology. If we go back to our
McDonalds option example, we were looking at the CALL option with a
strike price of $55 whilst the actual market price of the stock
was $54.56. In this case the option is called an OTM option as
it is '*out
of the money'*. Had we
been looking at the CALL option with a strike price of $57.50, then
this would have been called an ITM option -
'in the money', and finally had the
strike price and the market price been the same, then the option
is called ATM or 'at
the money'.
Whilst we have applied the above terminology to a CALL option,
it is also applied to a PUT option, but remember everything is
in reverse!! ( a put option increases in value as the underlying
asset falls in value ). A PUT option will be
out of the money if the strike price is
below the
market price, and in the money if the strike price
of the option is
above the
market price

Now whilst the terminology is not that important, the concept of whether an option is in the money, or out of the money is crucial, as every option has two principle components which affect its value as follows :

- Intrinsic value - the CASH value
- Extrinsic value - the TIME value

The intrinsic value of any option, is the amount the option is trading in or out of the money. In our example above where the strike price of the call is $55 and the price of the stock in the market is $54.56 then the option has no intrinsic value. So for an OTM option the intrinsic value is ZERO. If we now look at the option chain on the previous page we can see that the call option with a strike price of $52.50 has a premium bid and ask of $2.55 - $2.65. Now the market price of the stock at the moment is $54.56 so the call option has an intrinsic value of ( market price )$54.56-$52.50( strike price ) which is $2.06. This is the intrinsic value of the call option at this particular point. Now clearly this is below the premium being quoted of 2.60 ( taking the mid-point between bid and ask) by approximately 54 cents - so why? Clearly there is another element to the option's value, and this is the extrinsic value - the TIME element.

In
the above example of the call option, we were left with 54 cents
of 'value' in the option price. What does this amount represent?
The answer of course is the 'time' element of the option as
every option has a specific time until expiry. The time element
represents to traders the 'chance' that an **option** will finish in
the money, and of course, the longer the time available, then
the more likelihood there is that this will happen. Let's take
one of my silly examples which I hope will illustrate the point.
Suppose you are learning to drive, and have been given 6 months
to pass your test - are you likely to succeed - the answer is
probably yes as you have plenty of time to take lessons and
practice. Suppose you had now been given only 2 weeks - would
you pass - it's possible, but unlikely! So time is against you
in the second example, and as we all know, time passes quickly
when we have a deadline to meet.

So does this time element change - indeed it does, and not in
a
linear way either. As expiry approaches the extrinsic value
experiences time value decay and becomes the biggest enemy of
the option holder. Time is against them decaying faster and
faster, until on the day of expiry this element of the option's
value is zero as there is no time left. Above is a graphical
representation of how time behaves as the option approaches the
expiry date. As you can clearly see, as expiry approaches the
extrinsic time value starts to erode very quickly until it has
no value at expiry. Now as a option holder, time is always
working against you if you are hoping that an option will finish
in the money by expiry. Many, many traders will buy an out
of the money option, because it is cheap, thinking they have a
chance of it moving into the money. The reason it is cheap is
because it has no chance whatsoever of becoming a profitable
trade, and time works against the trader as the closer expiry
comes the less chance there is and the faster time decay works
as shown above! The entire premium of an ATM or OTM option is
time value since its intrinsic value is zero. Conversely an ITM
**option** at expiry is all intrinsic value since the time value is
zero.

One of the reasons I like the covered call writing approach to options trading is simply this, that as an options writer, time works for you, not against you. Time is on your side as the less chance there is that the option finishes in the money, the more chance that you will keep your underlying asset and be able to write another call on the stock. More of this later, but for the meantime, please take on board the above lesson - time works for you as an option seller, and against you as an option holder. For option holders time is liability not an asset. As option writers we use time to our advantage!!

OK, so we've looked at the component elements that make up the options price or cost, but what factors actually affect the options value. In total there are seven factors that play a part in influencing the options value and these are as follows :

- The type of option - Call or Put
- The price of the underlying asset
- The strike price of the option
- The expiry date of the option
- Volatility - Historic and Implied
- Risk free interest rate
- Dividends

Now, of the above list, the one that is most intuitive, yet
hardest to analyse is Volatility as there are two parts to it,
namely historic and implied which we will look at in a moment. But before moving on we have to discuss the issue of 'fair
value' and 'market value'. The fair value is the mathematical
calculation of what the options value 'should' be. You will no
doubt have heard of the Black-Scholes Options pricing model
which was devised by two mathematicians in the early 1970's.
This is still the most widely used theoretical model for valuing
options and you will find comparisons on most option chains of
the actual market value with the theoretical or fair value. Now
clearly market prices are set by the market forces of buyers and
sellers, and as you will see there is invariably a difference
between the perceived fair value, and the actual value. The
primary reason for this is in the interpretation of implied
volatility and historic volatility, as all the other influencing
factors shown above are fixed. It is this that we need to look
at next, as understanding these two factors will help you assess
those options and stocks that represent good **trading
**opportunities, and those that do not!!

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