Options - Basics Flashcards
Factors determining the price of an option
1.) price of the underlying stock
2.) strike price of the option
3.) time remaining until expiration
4.) volatility of the underlying
5.) current risk-free interest rate (e.g., for 90-day Treasury bill)
6.) dividend rate of the underlying
An option normally has the largest amount of time value premium when the stock price is _____ to the striking price.
EQUAL.
Time value premium shrinks substantially when the option becomes deeply in- or out-of-the-money. Other factors influencing the option price also diminish in importance the further in- or out-of-the-money the option is.
Intrinsic value of an in-the-money-call
The amount by which the stock price exceeds the striking price. If the call is out-of-the-money, tis intrinsic value is zero.
Time premium (aka time value premium)
NOT THE SAME AS the premium. The price an option sells for is commonly referred to as the premium.
HOWEVER:
The time premium is the amount by which the option premium itself exceeds its intrinsic value.
Call time value premium = call option price + striking price — stock price
Five main option Greeks
Delta
Gamma
Theta
Vega
Rho
Delta
The expected rate of change of an options premium due to a $1 change in the underlying.
Also can be used toe measure the approximate probability of that strike price expiring by 1 cent or more ITM. For example, an option with a delta of 0.50 has a 50% chance of expiring in the money.
In other words: What is the option’s sensitivity to the stock’s movement?
If Delta = 0.50, then the option price will change by 50 cents if the underlying changes by $1. Delta is going to be ca. 0.5 for an ATM call option. For deep ITM calls, delta rises to 1.00 and for deep OTM calls, it sinks close to 0.
For a put option, delta will be negative, and it will approach -1 for a deep OTM put option and approach 0 for a deep ITM put option. Puts show negative delta because they increase in value when the underlying goes down in price (negative x negative = positive).
Gamma
The expected rate of change of the options delta due to a $1 change in the underlying.
Think of it as the delta of delta – a second-order derivative.
Always positive for when long both call and put options.
An option with a gamma of 0.75 will see its delta move 3/4 of a point for every one-point move in the underlying asset’s price.
An option with a gamme of 1.00 will see its delta move one point for every one-point move in the underlying’s price.
Used by traders to gauge the potential for large moves in an option’s price:
** Options with high gamma are more likely to experience large price movements than options with low gamma. **
Theta
The expected rate of decay of the option due to the passage of time (1 calendar day).
The further out you go, the less money you lose to theta (time decay).
If theta = 0.25, expect to lose a quarter point in value per day if the underlying price stays still!
As expieration approaches, time decay accelerates if you are OTM.
Vega (Kappa)
The expected rate of change of an options preumium due to a 1% point change in the implied volatility.
Rho
The expected rate of change of an option’s premium due to a 1% change in risk-free interest rates (on US government bonds, i.e., the Fed Funds Rate).
Traders use options with high rho when they expect interest rates to move.
True or false:
When buying options, buy longer duration to have less impact from time decay.
When selling options, shorter duration (less than two months) works in your favor because the time decay screws the options buyer.
True
