Options come in two primary forms:
Calls and Puts
A call option gives the holder the right, not the obligation, to buy 100 shares of the underlying stock at a fixed price and for a fixed period of time.
A put option gives the holder the right, not the obligation, to sell 100 shares of the underlying stock for a fixed price and for a fixed period of time.
This is why an option is considered to be a "wasting" asset. Since the option only has value for a fixed period of time, its value decreases, or "wastes" away with the passage of time.
In the case of an index option, the holder can participate in the movement of the index.
However, these options are cash settled and therefore, the holder of the option will never wind up with a position in the underlying securities.
The Four Components to an Option
There are four components to an option. They are: The underlying security, the type of option (put or call), the strike price, and the expiration date.
Let"s take an XYZ November 100 call option as an example. XYZ is the underlying security. November is the expiration month.
100 is the strike price (sometimes referred to as the exercise price). And the option is a call (the holder has the right, not the obligation, to buy 100 shares of XYZ at a price of 100).
Types of Expiration
There are two different types of options with respect to expiration:
1. The European style option and
2. The American style option.
The European style option cannot be exercised until the expiration date. Once an investor has purchased the option, it must be held until expiration. An American style option can be exercised at any time after it is purchased.
Today, most stock options which are traded are American style options. And many index options are American style. However, there are many index options which are European style options.
An investor should be aware of this when considering the purchase of an index option.
The Parties to an Option
There are two parties to an option. There is the party who buys the option; and there is the party who sells the option.
The party who sells the option is the writer. The party who writes the option has the obligation to fulfill the terms of the contract should it be exercised.
This can be done by delivering to the appropriate broker 100 shares of the underlying security for each option written.
At-the-Money, In-the-Money, Out-of-the-Money
There are three different terms for describing where an option is trading in relation to the price of the underlying security.
These terms are "at-the-money," "in-the-money," and "out-of-the money."
Let's use our XYZ November 100 call as an example. If XYZ stock is trading at a price of 100, the November 100 call is considered to be trading "at-the-money."
If XYZ stock is trading at a price greater than 100, say 102, the call option is considered to be "in-the-money."
And if XYZ is trading at a price less than 100, say 98, the call option is considered to be trading "out-of-the-money."
Conversely, if it was an XYZ November 100 put option we owned, if the price of XYZ stock was 102, the put option would be considered to be out-of-the-money."
And if XYZ stock were trading at a price of 98, the put option would be considered to be trading "in-the-money."
If XYZ stock were again trading at 100, the put option would be "at-the-money."
Intrinsic Value and Time Value
The price difference between the underlying security and the option's strike price is the intrinsic value.
For example, let's take that XYZ November 100 call. If XYZ is trading at 102, and the call option is priced at 2, the intrinsic value is 2. If an XYZ November 100 put is trading at 3, and the price of XYZ stock is trading at 97, the intrinsic value of the put option is 3.
If XYZ stock were trading at 99, an XYZ November 100 call would have no intrinsic value. And conversely, if XYZ stock were trading at 101, an XYZ November 100 put option would have no intrinsic value. An option must be in-the-money to have intrinsic value.
Time value is the amount by which the price of the option exceeds its intrinsic value.
For example, that XYZ November 100 call, with XYZ trading at 102, might be selling for 4-1/2. Thus, there is 2 points in intrinsic value and 2-1/2 points in time value. If XYZ were trading at 99, and the price of the option was 2, there would be no intrinsic value and 2 points in time value. If an XYZ November 100 put was priced at 3 and XYZ stock was trading at 99, there would be 1 point in intrinsic value and 2 points in time value.
If an XYZ November 100 put was trading at 2 and XYZ stock was priced at 101, there would be 2 points in time value and no intrinsic value. The time value premium of an option declines as the expiration date approaches.
Intrinsic Value + Time Value = Option Price
Factors Influencing the Price of an Option
There are four major factors which determine the price of an option. They are:
The price of the underlying stock. The strike price of the option itself. The time remaining until the option expires. The volatility of the underlying stock.
Two less important factors in determining the price of an option are: 1. The current risk free interest rate. 2. The dividend rate of the underlying stock.
The primary influence on an options price is the price of the underlying security. On expiration day, if I own one XYZ November 100 call, and XYZ is trading at 95, my call is worthless. On the other hand, if I own one XYZ November 100 call, and the price of XYZ on expiration day is 102, my call is worth at least 2 points.
An options price decays each day it is in existence. Further, the closer the option gets to expiration, the faster it decays.
The rate of decay is related to the square root of the time remaining.
An option with two months remaining decays at twice the speed of a four month option etc.
The volatility part of the pricing model is a measure of the range the underlying security is expected to fluctuate over a given period of time.
The measurement of volatility is the standard deviation of the daily price changes in the security.
The more volatile the underlying security, the greater the price of the option.
There are two different kinds of volatility. There is historical volatility; and there is implied volatility.
Historical volatility estimates volatility based on past prices.
Implied volatility starts with the option price as a given and works backward to ascertain the theoretical value of volatility equal to the market price minus any intrinsic value.
Option Pricing Models
There are many different option pricing models in practice. However, the original breakthrough was in the Black-Scholes model. It was a model for pricing options before options were widely traded.
The original Black Scholes model worked primarily for European style options. However, it has been modified to work with American style expiration.
Since then, several variations have been developed.
The Cox Rubenstein model and Yates models are two widely used models for pricing American style options.
There are other binomial option pricing formulas. And some options are priced according the cost of the hedge for the specialist/market maker.