This is a summary of the very basic terms and concepts of options, including calls and puts, option premium, intrinsic value, time value, implied volatility, and the Greeks. You can follow the links to get a more detailed explanation with examples.
Definition and Basic Logic of Options
- Option represents a right, but not obligation, so it is generally better to own options than not own options.
- Options are derivative securities and every option is derived from an underlying asset or security.
- There are options on various types of underlying assets including stocks, ETFs, indexes, currencies, bonds, interest rates, futures, swaps, and many more.
- Call options represent the right to buy the underlying asset.
- Put options represent the right to sell the underlying asset.
- Read more: What an option is, call options, and put options
Trading and Exercising Options
- The owner of an option can decide to exercise it or not.
- Every option has limited life and after that time period it expires.
- American options can be exercised at any time before or at expiration. European options can be exercised only at expiration.
- Read more: Exercising options and expiration
- Some options trade on option exchanges and their contracts are standardized. Options on US stocks traded on the CBOE (Chicago Board Options Exchange) are an example.
- Other options trade OTC (over-the-counter), without an exchange.
Strike Price of an Option
- Every option has a fixed strike price, which is the price that applies to the buying or selling of the underlying asset when the option’s owner exercises the option.
Market Price and Intrinsic Value of Options
- Market price of an option (or market value or option premium) consists of intrinsic value and time value. Market price is something totally different from strike price.
- Read more: Strike price vs. market price vs. underlying’s price
- Intrinsic value is the difference between the strike price and current market price of the underlying.
- Intrinsic value can’t be negative.
- When the underlying asset’s price grows, intrinsic value of a call option goes up as well.
- Read more: Strike price and intrinsic value of call options
- Intrinsic value of put options moves inversely to the underlying’s price and to intrinsic value of call options. When the underlying asset’s price grows, intrinsic value of a put option falls.
- Like with a call, intrinsic value of a put option can’t be negative.
- Read more: Strike price and intrinsic value of put options
In the Money, At the Money, Out of the Money
- Options with intrinsic value are said to be in the money.
- Options whose strike price is equal or very close to the current market price of the underlying asset are said to be at the money.
- Other options, which have no intrinsic value, are said to be out of the money.
- Call options are in the money when their strike price is lower than the current market price of the underlying asset.
- Put options are in the money when their strike price is higher than the current market price of the underlying asset.
- Read more: In the Money, At the Money, Out of the Money Options
Time Value of Options and Time Decay
- Time value of an option depends on many factors, primarily on the option’s moneyness, time left to expiration, and volatility.
- Read more: Time value of in the money call options, in the money put options, and out of the money options
- The more time is left to expiration, the higher the time value (other things being equal).
- The decrease in options’ time value with passing time is called time decay.
Historical and Implied Volatility
- The higher the volatility, the higher the time value (other things being equal).
- We distinguish historical and implied volatility.
- Here you can find more information and resources on volatility.
- Historical volatility is volatility observed on the underlying asset’s price in the past. We can calculate historical volatility using historical data.
- Implied volatility is volatility of the underlying asset’s price expected by market participants and reflected in option prices. We can calculate implied volatility using an option’s market price and an option pricing model (we need to set the other parameters in the model).
- An example of option pricing models is the Black-Scholes Option Pricing Model.
- Different options on the same underlying asset and same expiration can have different implied volatility.
Delta, Gamma, Theta, and Vega
- Options’ exposures to external factors can be measured by the so called Greeks.
- The most important Greeks are delta, gamma, theta, and vega.
- Delta measures exposure of an option’ market price to changes in market price of the underlying asset.
- Read more: Measuring directional exposure with delta
- Gamma measures exposure of an option’s delta to changes in market price of the underlying asset.
- Theta measures exposure of an option’s market price to passing time.
- Vega measures exposure of an option’s market price to volatility.