Chapter 3 : Trading Place where Action Happens

Option moneyness :

Options are said to have a certain moneyness, which describes relative information about the intrinsic value of a contract. The calculation for intrinsic value can lead to three different results in terms of moneyness:
»»In-the-money (ITM) when Intrinsic Value > 0
»»At-the-money (ATM) when Intrinsic Value = 0
»»Out-of-the-money (OTM) when Intrinsic Value

Intrinsic Value (Call) = Market Price of Stock – Option Strike Price.

Intrinsic Value (Put) = Option Strike Price – Market Price of

Grasping Key Option Pricing Factors

Option prices are determined by the type of option (call or put), its strike price, the price of the underlying stock, and the time remaining to expiration. Prices are also determined by the volatility of that underlying stock.These measures are available for each individual option and are referred to as the option Greeks, because most of their names are derived from Greek letters.

Introducing option Greeks

An option’s Greeks are individual variables that combine to provide you with the value of expected changes in the option, given changes in the Underlying Stock.

»»Delta: Represents the expected change in the option value for each Rs.1 change in the price of the Underlying stock.
»»Gamma: Represents the expected change in delta for each Rs.1 change in the price of the underlying stock.
»»Theta: Represents the option’s expected daily decline due to time.

»»Vega: Represents the expected change in the option value due to changes in volatility expectations for the underlying stock.

Delta
Delta is probably the most important Greek value for you to initially understand because it connects changes in the underlying stock’s value directly to changes in the option value. Delta values range from:
»»Calls: 0 and 1.00 or 0 and 100 »»Puts: 0 and –1.00 or 0 and –100

Gamma
Gamma provides you with the expected change in delta for each Rs1 change in the price of the underlying stock. By understanding and checking gamma, there’s less of a chance that delta values will get away from you.

Connecting past movement to the future

Past movement in the underlying stock is used to determine the probability that a certain minimum or maximum price will be reached. As you know, past movement doesn’t provide you with a map of what’s going to happen during the next month, next week, or even next day.

Historical volatility

Historical volatility (HV) is a measure of past movement in a stock. It is also referred to as statistical volatility (SV). To calculate HV, you must do the following:

1. Calculate the daily price change over a set number of days.
2. Calculate the average value for price change over that period.
3. Determine how each daily price change compares to that average value by taking the standard deviation for the price changes in the set.
4. Divide the value in Step 3 by 0.0630 to approximate an annualized standard deviation.

Implied volatility :Each day, news is released that impacts expectations going forward. This is where implied volatility (IV) enters the picture.

Implied volatility (IV) is one component of an option’s price and is related to the time remaining until expiration. On a given day, you can identify as follows:
»»Current price for a given stock

»»Nature of past movement for the stock

»»The type and strike price for a particular option

»»The number of days until that option expires

An option calculator that uses HV in the volatility field will provide you with the following when you click Calculate:
»»The theoretical value for both the call and put at that strike price

»»The theoretical Greeks for both the call and put.

Theoretical option values are based on HV, versus actual option market prices, which are based on IV. These values are compared to artfully determine if future expectations reasonably reflect what’s happened in the past for the stock. Even when actual prices exceed model prices, the option may still represent a trading opportunity.