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| Don Kaufman, here. |
| I want to talk to you about something near and dear to my heart when it comes to trading…and that’s options. |
| I spent 15 years at thinkorswim where I had a front-row seat to the largest options order flow in the industry. I didn’t just observe what millions of retail accounts were doing…but I studied them |
| And let me tell you…A LOT of traders fail because they never get the basics right. |
| Without a firm grasp of the basics you’ll trade the wrong options with the wrong strategy which will end up costing you a bundle of cash. |
| To avoid these pitfalls you must take the time to understand how options are priced. |
| So, game on! |
| Let’s break this down. |
| First things first, stock options are priced using mathematical models. You’ve probably heard of the Black-Scholes-Merton model – it’s the rock star of option pricing. |
| But don’t worry, we’re not going to get bogged down in the math. Instead, let’s focus on what really moves the needle in option pricing. |
To price an option, you need to know six key factors:
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- Current stock price
- Strike price
- Time to expiration
- Stock volatility
- Interest rates
- Cash dividends
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| Let’s take a closer look at each of these, and I promise you, by the end of this, you’ll have a much clearer picture. |
Current Stock Price:
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| This one’s pretty straightforward. As the stock price goes up, call options become more valuable, and put options less so. It’s like a see-saw – when one side goes up, the other goes down. |
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| For example, if a stock jumps from $100 to $102, you might see a call option value increase from $1.73 to $2.93, while a put option drops from $1.71 to $0.91. It’s all about the relationship between the stock price and the strike price. |
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Strike Price:
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| Now, this is where we get into the lingo of options trading. We classify options as OTM (out-of-the-money), ITM (in-the-money), or ATM (at-the-money). |
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- ATM options have a strike price close to the current stock price.
- ITM call options have a strike price lower than the stock price.
- OTM call options have a strike price higher than the stock price.
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| For calls, the higher the strike (more OTM), the cheaper the option. For puts, it’s the opposite – higher strikes are more expensive. It’s all about probability, folks. |
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Time to Expiration:
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| Options are wasting assets, plain and simple. The more time left, the more valuable the option. |
| Why? |
| Because there’s more time for the stock to potentially move in your favor. As expiration approaches, that time value bleeds away. |
| That said, the more time an option has remaining, the more expensive it is and vice versa. |
| At expiration, the option will either close ITM or expire worthless. |
Implied Volatility:
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| This is where it gets juicy. Higher volatility means more expensive options – both calls and puts. |
| It’s like betting on a wild horse race versus a predictable one. More potential for big moves means more value in those options. |
| This is where a savvy trader will look at an options chain and buy options that are relatively cheap and sell options which are relatively expensive. |
| In fact, one of my most successful strategies is based on this principle. |
| Whenever you hear someone say options are expensive or cheap, they are usually referring to the options volatility. |
| In times of uncertainty option volatility is high, and its relatively low when the market doesn’t expect surprises. |
| For example, before an earnings announcement option volatility will be sky high because of the unknowns. However, after the news is digested, option volatility gets sucked out because our questions about the company are answered. |
Interest Rates:
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| Now, we’ve were in a low interest rate environment for ages, so this wasn’t as crucial as it is now. All you need to know is – higher rates generally boost call values and decrease put values. |
Cash Dividends:
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| Last but not least, dividends. As dividends increase, put options become more valuable, while call options lose some value. It’s not a major player for most trades, but it’s part of the bigger picture. |
| Look, I know this is a lot to take in. |
| But here’s the deal – understanding these factors is like having the keys to the kingdom in options trading. |
| My advice? |
| Play around with an options calculator or price some different options on the same symbol. |
| Get a feel for how these factors interact. Once you’ve got this down, then we can talk about the sexy stuff like Greeks and advanced strategies. |
| Remember, in this market, knowledge is power. |
| And now you’ve got some serious firepower when it comes to understanding options pricing. |
| Stay tuned, because we’ve got a lot more to cover in this options game. |
| To your success, |
| Don Kaufman |
