You have identified good stocks that are expected to make big market moves and you have made some money in the stock market by applying this strategy in a disciplined way. However, it is up to you if you can time your move and use that movement to your advantage. If you are consistently failing to do the same, it is time to shift to options trading.
Options pricing is based on the following 4 factors:
- Strike price
- Stock’s market price
- Volatility
- Time until expiration
These factors determine the intrinsic and extrinsic pricing of the options. We will discuss all these in detail in this article.
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Options – The pricing strategy
Options give you the right as a holder to buy or sell an asset at a pre-agreed price. Since the value of an option is derived from the associated underlying asset, they are also called derivatives contracts.
Remember, you do not own the asset and are not even obligated to buy or sell it. You can walk away before the expiry.
The 2 parties involved in the trading of an option are buyers and sellers. The buyers on one hand get the contract rights; on the other hand, the seller is bound with an obligation to sell before the expiry.
Options are of 2 types:
1.Call options:
- Call buyer gets the right to buy the underlying asset at the strike price.
- Call seller is obligated to sell the asset at the time of expiry .
2.Put options:
- Put buyers are receiving the right to sell the asset at the strike price.
- Put sellers are obligated to buy the asset at the end of contract expiry.
The options contracts are bought at a price that is a fraction of the price of the original stock or asset. This price is called premium and pricing correctly is very important for trading.
The most commonly used option pricing model is Black-Scholes Model. It is used to determine the market value of an option fairly. Let us discuss the 4 factors affecting the options pricing as mentioned at the beginning of the article:
1.Strike price: It is the pre-agreed price of the options contract at which we buy or sell at expiration.
2.Stock’s market price: It is the current value of the stock in the market.
The longer the time value, the greater are the chances of stocks expiring in the money. This results in profits.
Many mathematical models are used to derive all these parameters. As a trader, you need to understand the importance of volatility and time value in affecting the price of options and thus, your profits as well.