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Duration: 10:55

Instructor:

Contributor: Interactive Brokers

Level: Intermediate

Reinforces an understanding of options contracts and investment outcomes using payout diagrams. Obtain insights into options pricing models and associated variables, including implied volatility and interest rates, as well as concepts such as time value, option style, and how dividends can affect options prices.

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Study Notes:

Call options convey to the buyer the right but not the obligation to purchase a set number of shares of an underlying asset at a predetermined price known as the strike price prior to the time that the option contract expires.

A call option buyer does this with the expectation that the price of the undying asset will rise at some point prior to expiration. The buyer of the option pays a premium to the seller for this right.

For a call option the premium can be shown as a fixed cost beneath the chart. If the market price of the underlying asset rises above the strike price the cost of the premium is offset by an increase in the option’s value and the option may become increasingly profitable.

If not, an option buyer can lose the entire premium. The option seller may have unlimited risk of loss. Options involve risk and are not suitable for all investors.

For more information read the characteristics and risks of standardized options. For a copy call (312) 542 -6901.

Put options convey to the buyer the right, but not the obligation, to sell a set number of shares of an underlying asset at a predetermined price, the strike price, prior to the time that the option contract expires.

A put option buyer does this with the expectation that the price of the underlying asset will fall at some point in the future. The buyer of the option pays a premium to the seller for this right. For a put option, the premium can be shown as a fixed cost beneath the chart. As the market price of the underlying asset decreases beneath the strike price, the cost of the premium is offset by an increase in the option’s value and the option becomes increasingly profitable.

Options provide investors with more leverage, and thus more risk, than is available with stocks. Given identical investments, profits and losses are magnified. However, option holders unlike shareholders do not receive the underlying company’s dividends or voting rights.

  • For example, assume an investor buys 1000 shares of company XYZ corporation at $10 each for an initial capital outlay of $10,000.
  • If the share price increased to $11 the investor’s capital would increase to $11,000 dollars for a 10 percent gain. With option contracts a 10 percent moving the value of the underlying asset could translate into a larger increase or decrease in the price of the option. In the example, a premium of $0.50c is paid for a call option with a strike price of $10.25 cents. If the market value of the underlying asset price rises to $11 the option value rises to $0.75c and can be sold for an increase of 50 percent.

Option premiums and the subsequent changes in option values can be predicted through a pricing model such as Black Scholes. Because we don’t want to overwhelm you with formulas we’ll simplify things by taking you through the basic inputs of an options pricing model and let you see how each input impacts an option’s value.

Standard inputs of an options pricing model are strike price, interest rate, implied volatility, underlying asset price and time to expiration.

The strike price represents the predetermined price at which an option contract may be exercised where a call option buyer can buy the underlying asset from an option seller or a put option buyer can sell the underlying asset to an option seller.

  • Consider a company whose share price is $32.90. An investor who expects the share price to rise is considering buying a call option at strike prices of $33 or $35. The investor expects the share price to rise within the following 90 days. The question the investor faces is what price should be paid for the rights conveyed by the call option?
  • The probability of the share price rising to the $33 strike is greater than the probability of the shares rising to $35. Therefore, the premium cost for the $33 strike option would be higher than the premium cost of the $35 strike option. The opposite is true for put options since they convey selling rights. In this case the price of a put option at the $28 strike would be more costly than a put option offering the right to sell at a lower $25 strike.

The rate of interest is a factor in determining the premium cost of an option. That’s because investors are faced with an allocation choice between various assets including the risk-free rate of interest on government securities. Investors tend to set the value in the calculator at the rate available on government bills for the period of the option.

While the rate of interest is a factor, its significance in the current market is fairly low.

Having already noted the importance of the relationship between underlying asset and strike price to an option’s price, it would stand to reason that the outlook on future underlying asset price movements would affect the price of an option.

The greater the forecasted price movement, or implied volatility, the greater the probability that an option will increase or decrease in value. Therefore, the greater the implied volatility, the greater the potential for the options price to change.

Implied volatility does not suggest whether prices will go up or down, only that prices will move implied Volatility, or a future outlook on price movements, should not be confused with historic volatility. While historic volatility may be a guide to determining implied volatility, an options pricing model requires an estimate of implied volatility during the option contract period.

Option market participants know the underlying price, strike price, interest rate and number of days to Expiration. Current option prices are readily available from the exchanges and therefore implied volatility can be backed into by an option pricing model.

Knowing implied volatility across a range of differing underlying assets, strike prices, call options and put Options, allows a trader to easily compare options and determine if price opportunities exist in the market.

The relationship between the strike price and the underlying asset will have a strong influence on the price of an option. For a call option the higher the underlying asset price in relation to the strike price the higher the option premium.

The payout at exercise of the option is the difference between the underlying asset price and the strike price. Options with an underlying asset price below the strike are out-of-the money, at the strike are at-the-money, and above the strike are in-the-money.

For a put option the lower the underlying asset price in relation to the strike price, the higher the option premium. The payout at exercise of the option is the difference between underlying asset price and the strike price. Options with an underlying asset price above the strike price are out-of-the money, at the strike at-the-money, and below the strike in-the-money.

Remember that, even though the option may be in-the-money it may still results at a loss when considering both the premium and commission paid for the option. While we are not factoring these costs in for the sake of simplicity they should be considered when determining the break-even point for the option contract.

An option expiring today would be worth the amount by which it is in-the-money. If it is at-the-money or out-of-the money, then it has no current intrinsic value. An option that has time before expiration generally has extrinsic value. The extrinsic value represents the probability that an options underlying asset value will move in the future giving it the potential to produce an increase in intrinsic value. The more time until expiration the greater the probability that an underlying asset’s move will increase an option’s intrinsic value. Therefore, for both puts and calls the greater the time until expiration the greater the extrinsic value. An option’s premium or market value is equal to its intrinsic value plus its extrinsic value. At option expiration there is no extrinsic value remaining and so the option’s market value will be equal to its intrinsic value.

Two other factors that could affect an option’s price are option’s style and dividends.

Option style determines when an option can be exercised. American-style options can be exercised at any time prior to, up to, and including the day of expiration. While European style options can only be exercised at expiration. All models in these lessons assume American-style options, which is the most common type of US option. Dividends tend to affect an option’s price most when there are changes in the dividend amounts and around ex-dividend dates due to the value of the dividend upon exercise up until the ex-dividend date.

Now that we have covered the option pricing model you should have a better understanding of how changes in all of the inputs may affect an option’s price. You should also note that rarely does these inputs change in isolation.

Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Supporting documentation for any claims and statistical information will be provided upon request.

Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.

Disclosure: Margin Trading

Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.

For additional information regarding margin loan rates, see ibkr.com/interest

Disclosure: Options Trading

Options involve risk and are not suitable for all investors. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD). To receive a copy of the ODD call 312-542-6901 or click here. Multiple leg strategies, including spreads, will incur multiple commission charges.

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