Option Pricing 101 | Options Crash Course

[Music] i'm jim schultz and welcome back to the options crash course man i thought we got off to a pretty good start yesterday talking about the source to all strategies so i thought hey today let's continue this little fireside chat and let's forge ahead so let's get into it man let's not waste any time so what we're going to do here on episode number two of the crash course is we are going to deconstruct some option prices now guys i got to say this on the front end i said this yesterday you're probably going to hear me say this every single time right we don't have the opportunity to go through all the minutia that there is to go through when it comes to each and every topic that we're going to cover we're going to try to paint with a broad enough brush right lay down big enough bricks so that just in case we miss a little bit of mortar we won't even know it's gone so i have to make some concessions along the way so be you know be advised be aware that we're not going to cover every you know last detail when it comes to option prices but we should be able to get you guys far enough along the learning curve to where you guys can start building a portfolio so all right so the options crash course crash course that is week number one so yesterday we talked about the source of all strategies today we're going to deconstruct some option prices day number three which will be tomorrow we're going to talk about some extrinsic value extras and then we're going to round out this week number one with profit direction and probability on friday so for those of you that maybe didn't catch the episode yesterday i will link to it down in the show notes so you guys can easily find it and so let us begin all right option so we're going to effectively go over two different elements two different angles to option pricing the first one being the black shoals model so the black shells option pricing model this is the governor to all things option pricing this is the thing that is controlling an options price at any moment that you see it throughout the day there are other models that kind of simulate what the black soles model does there are other equations that kind of mimic the outputs from the black shells model but the black shells model was the seminal equation was the seminal discovery by black and shoals some 50 or 60 years ago and these guys helped us understand what is controlling option prices effectively there are six different inputs that are controlling option prices now my objective here is not to go through each and every input you know in an exhaustive way we want to pull out what we need to build healthy portfolios as tasty traders right we want to take a look at these elements to better understand them and better appreciate them but we also want to simply stop when we have effectively you know found what it is we're looking for now we're going to revisit the black souls model you know five or six times after today so we'll keep coming back to this guy but my goal is not to offer up a proof of the black shells you know option pricing model thank god the second thing the second thing is that the model itself is dynamic the model itself is fluid the model itself is changing in real time so be aware that not only are all the inputs changing but of course the outputs are changing from the model too and this is all happening behind the scenes it's happening right now as you guys are watching this in real time it's happening right now if you guys are watching this you know in the archives the black shoals option pricing model operates on what is known as a continuous framework so it is always working it is assuming an infinite number of time slices in all of the calculations that it's going to go ahead and churn out the second thing that we're going to focus on today once we take a look at the black shells model we're going to understand how prices further break down into their two component parts intrinsic value and extrinsic value now with this one idea alone there are all kinds of layers and nuances and subtleties and all these different things that are going on with intrinsic value and extrinsic value and we have a slide dedicated to each one you know for the next 17 or 18 minutes and we'll keep coming back to these guys too but right now the most important thing that i want you guys to grab on to again i'm assuming you don't you know nothing i'm assuming the only thing that you know is episode number one right i'm assuming the only thing that you understand to this point is the option contract and the transaction with the market maker facilitation that's it if you think about intrinsic value and extrinsic value as simply being the additive function to arrive at an options price it's going to help you build that foundation it's going to help you lay down that you know all important brick that is intrinsic value extrinsic value leading to the options price that's probably three bricks but nevertheless we move on so the big daddy bsm so take a look at what we have here on the slide now i know some of you probably are looking at that and you had a little bit of a panic attack you're like okay i don't know that i understand what's going on on this slide and i don't know that i want to spend any time to understand what's going on this slide well again i'm going to move through this you know with some brevity and some efficiency as our number one goal again the goal is not to unpack you know all of you know the the the derivations behind the black shells option pricing amount for those of you out there that have a hankering to understand you know how the black shells model was built created and all the implications i would encourage you to google black shield's model from theory to practice tastytrade put that all in your google stream and you my friend will have all kinds of binge-worthy content ready to go for this weekend i have a feeling that your wife or husband is going to be pretty fired up about that but if we take a look at this equation we effectively see two terms and this is what i want to focus on here you see the first term you know that that s and d1 that is effectively capturing the value of the stock price now the black scholes model in its entirety again kind of painting with a super broad brush it's a probabilistic function that has a discounting factor now what does that mean in english all it means is it is weighing the different probabilities of various events occurring you know both now and into the future when the option expires and it is discounting the prob those probabilities back to real time back to what we see right now and so when we look at these two terms that's exactly what it does it takes the value of the stock and it figures out okay the value of the stock now but let's also let's forecast that guy forward let's push that guy forward out to expiration and let's see what it might be worth at expiration you know given a certain set of conditions let's also do that with the second term that's in this equation that's the value of the strike price so it's again going to take you know the the absolute value of the strike price the value of the strike price today and it's going to forecast that forward like okay what might the value of the strike price be you know come expiration and what is effectively going to do to price a call option which is what we're doing here you see that on the left hand side we are going to figure out what is the incremental value of this call option we learned this yesterday right a call option is going to have value if the value of the stock exceeds the value of the strike we saw that yesterday we're going to see it again in the next you know seven or eight minutes if the value of the stock exceeds the value of the strike then the call option should be worth something right so if the first term is greater than the second term then you have some positive value for the call option now there's more to it than that and we're going to unpack this a little bit more in the next few minutes but this is all i want you guys to grab on to right now this is how the black shoals option pricing model begins to set up the six inputs that go into this model the stock price the strike price implied volatility interest rates time and dividends these are the six inputs that go into the model to compute the options price now again we're not going to go through all six of these today we're not gonna go through all six of them you know ever to be honest with you i don't know that i'm gonna have too much to say about interest rates because let me tell you guys a little insider hack nobody gives a rip about interest rates in the black souls option pricing model they just don't really matter too much maybe if you're a bond trader that might matter for you but you guys are pretty few and far between we'll come back to these as we need to faq a lot of people ask me when they learn this for the first time they're like jim all right wait a second man like i'm with you for the most part i mean you lost me a little bit there you know when you're going through you know probabilistic density functions but what about the put options where are the put options in this equation right this is valuing a call option how do i figure out the value of a put option well if you know the value of a call option there's a second equation that i'm not going to cover in the crash course because it's more of a tertiary idea called put call parity put call parity effectively allows us to calculate the value of a put if we know the value of a call and if we know the value of the put we could figure out the value of the call too so if we know the call we can figure out the put if we know the put we can figure out the call given all the other inputs that you see here on the screen so we're not going to value the put option in this crash course but just understand that it is indeed being valued by the black shields model okay so let's turn our attention now to intrinsic value so what i have here on the screen is i have four little you know let's call them cards that kind of set us up for different scenarios and circumstances to understand what intrinsic value would look like the first thing you want to understand and be aware of is a working definition of intrinsic value intrinsic value is basically the worth of the option intrinsic value means nothing more than the inherent worth to the option now here's the most important thing that you guys can pull away from this slide and honestly let's let's pause for just one brief second for station identification and one really important tip for those of you that are learning options for the very first time guys i got blown up with emails last night it was terrific right people are reaching out to me on email and twitter and whatnot saying hey i found the crash course i'm just starting like this is great i'm like yeah this is great because this is for you if you are just learning options for the very first time here is the best piece of advice that i could have for you at this juncture in the crash course again this episode number two when you're trying to understand long call long put short call short put or just long options and short options in general it's much much much easier to view the options from the long option perspective from the long side of the contract's perspective once you understand what's happening on the long side of the option contract you de facto know what's happening on the short side of the option contract and the reason why that's the case is you may have heard this term before options are referred to as a zero sum game so what that means is whatever one side wins the other side loses whatever one side loses the other side wins it's perfectly clean it's always the case and so if that's true if i can figure out what's happening on the long side of the contract then i also know the the effect on the short side of the option contract because it is effectively the mirror image of what i just found so keep that in mind as we're working through this little slide deck that i have right here okay so let's go back to these four cards and we'll work through these we'll work through these fairly quickly as i think that they're going to be very straightforward so i'm working with the left hand most cards so this is a call option and let's pretend that the price of the stock is 110 the strike price on the option is 100 what is the intrinsic value of this option well if you're looking at the screen you can see it in orange it is 10 so how did we know that it was 10 well again think back to the call option and think back to the call option from the viewpoint of the long side of the contract if i'm holding this call option i have the opportunity to buy this stock for 100 when it's actually worth 110. so there's an inherent worth to my holding this contract right i effectively have a baked in gain if you will of 10 because i can buy something for 100 that's actually worth 110 that is intrinsic value now move to the right to the next card so the second one from the left this is also a call option if the price were 80 and the strike price were still 100 now the intrinsic value drops to zero now why is that the case well think about it if i'm holding this contract it gives me the opportunity to buy the stock at 100 i don't have to do it i'm not forced to use it but i have the the right i have the privilege i have the opportunity to do this but if i'm looking at the situation and i'm looking at this piece of paper you know and i'm like okay this is my option contract and this option contract gives me the right to buy this stock for 100 and i'm looking at the open marketplace and it's selling for 80. why why would i use this contract right why this is worthless to me this has no inherent value to me so in this case the intrinsic value is zero okay so moving further to the right so now we're in kind of that that grayish bluish you know uh slatish color that's on the slide for the put options so if the price were 60 and the strike price were 80 this would have an intrinsic value of 20. now why is that the case well again think about it from the long holders perspective the price of this instrument this stock is 60 but the strike price on my put contract is 80. that's giving me the right to sell this stock at 80 when it's actually only worth 60 that has a baked in value of 20 moving all the way to the right to the final card but what if the price were 90 on this put situation and the strike price on this put contract were 80. now all of a sudden again think about it just intuitively right think about it just logically i have a contract that allows me to sell something for 80 but if i go into the open marketplace i can sell it for 90. why would i use that contract nobody's going to use that contract so the intrinsic value there is zero so hopefully this is starting to make a little bit of sense faq can the intrinsic value ever be negative and the answer is no the intrinsic value the minimum bound on intrinsic value is always zero and the reason why that's the case is if you look at the second card and the fourth card are two scenarios where the intrinsic value was zero you just walk away right if i'm the long side again hopefully you guys are starting to appreciate how beneficial it is to view this from the long holders perspective if i'm the long side of these contracts i can just walk away i don't have to use these contracts i'm not required to use these contracts i'm not forced to exercise these contracts right that's one of the benefits to the long side of the contract and we began to see that you know in yesterday's episode number one so intrinsic value can never be negative its lowest value is zero which would be the case if the contract has no inherent worth it has no value to the long side okay so that's intrinsic value let's now turn our attention to extrinsic value so extrinsic value extrinsic value is basically your kicker extrinsic value is basically your added premium that you kind of tack on top of the intrinsic value to arrive at the full option price so for example let's say that you were looking at an option price and it was five dollars and of course we now know from yesterday right all options don't have one price they have two prices they have a bid price and an ask price so let's suppose that the mid price between the bid and the ask is five dollars one possible breakdown of the extrinsic value and the intrinsic value might be three dollars of intrinsic value and two dollars of extrinsic value just to simplify things on this slide i didn't even include if we were talking about calls and puts and things of that nature i really wanted to just simplify this concept of extrinsic value we're going to talk in a lot more detail about extrinsic value on tomorrow's show on episode number three so if i'm looking at this scenario intrinsic value might be three dollars extrinsic value might be two dollars that's one possible breakdown if i look at the second column intrinsic value might be one dollar extrinsic value might be four dollars that would be another possible breakdown of an option price that is anchored at five dollars on the mid price or i could be looking at a scenario like on the cards we saw on the previous slide where the intrinsic value is actually zero right the option has no inherent worth to the long side of the contract but the extrinsic value in the option is still some positive number it's five dollars and we're going to see that's very very very important remember this scenario where you have no intrinsic value but you have some extrinsic value we're going to see in a real-time example here in just a couple of minutes but we're going to see it again tomorrow and we're going to see it maybe a couple dozen more times over the course of the next 15 or 16 days together so when i'm looking at this scenario of course these are not the only three possibilities if an option price is five dollars it could be broken down any infinite number of ways but these are just three examples to show you how intrinsic value and extrinsic value work together to determine that full option price now naturally the the classic fa key right here is like all right jim i understand how these things break down at least at least a little bit at least loosely which that's all we're going for right now but what i want to know is what determines these values what determines the intrinsic value and the extrinsic value well i have two answers to that question the first of which believe it or not you already know in fact you learned it about 11 minutes ago it's the black shells option pricing model the black shells option pricing model determines what the intrinsic value and the extrinsic value should be for any given option any given strike in any given stock across you know all the expirations that are available to us but there's a second answer and we're going to see that a little bit more tomorrow but okay so let's take this idea in my final couple of minutes here and then we'll get you guys right over to uh to tim knight trading the clothes for those for those of you that might be watching live on the tastytrade network let's look at some real time extrinsic so i color-coded the two examples that i have here on the slide of course i took this screenshot from the tastyworks software and if you look at the white the white arrows the white ovals the white rectangle let's focus on that first so if i look at that 332 strike what do i notice well i noticed that the price obviously it's frozen the the prices are not bouncing around in real time so i guess it's a little bit of a misnomer to call this real time but hopefully i can still capture the spirit of it being in real time since i did capture this just yesterday the price of that 332 call is it looks like about eleven dollars or about eleven dollars and five cents on the mid price that's the first thing that i want us to understand look immediately to the left of the rectangle so in that oval right there you see the extrinsic value so there's another oval near the top of the screen that you know kind of denotes the label of that column that's the extrinsic value so tastyworks tells you what the extrinsic value is in the option and here you can see it's about nine dollars and sixty cents so naturally i'm like okay i have an option that's selling for about 11 bucks just to make the numbers easy it has extrinsic value of about 960 so there's a gap right there's some missing component there that difference of course is intrinsic value so this option this call option we're on the left hand side of the screen so you can see we're working with calls here this has some inherent worth to the long side okay move over to the right hand side the yellow example that's on this slide if i look at that 328 strike look at the price of this guy it's about 942 or 943 on the mid price look immediately to its right and what do you see the extrinsic value is 9.42 so in this situation what do we have on our hands we have an option there is no intrinsic value but it is currently sitting with over nine dollars of extrinsic value so this is an example like what we just saw on the previous slide where you have no intrinsic value and only extrinsic value and so i kind of wanted to start to put these pieces together for you guys so that when you open up your tastyworks platform and you start building out that portfolio and you come across you know bid prices ask prices extrinsic values strike prices all the things we've already begun to talk about you won't be super overwhelmed and you'll be able to make some sense of what you see in front of you so i'm pretty much out of time today but here's what we're going to cover tomorrow so i've already alluded to this a little bit we're going to cover some extrinsic value extras i want to dig into this idea of extrinsic value in a lot more detail with a fine-tooth comb and let me be the very first to welcome you to the world of moneyness there is no going back from here so that's all i've got for you guys man don't forget you guys can always email me with questions comments whatever you guys got for me i would love to hear from you it's just jay shultz at tastytrade.com if you want to hit me up on twitter that would be great too just at jsultsf3 but we do have tim knight trading the clothes coming up next in the meantime guys trade them small train them heavy and stay optimistic we'll see you guys tomorrow [Music] you

Channel: tastytrade

Views: 28,081

Rating: 4.9610391 out of 5

Keywords: investing, finance, how to, education, curriculum, course, learn, trading, options, tastytrade, portfolio, learn to trade, stock, basics, put, call, trading strategies, trade management, intro to options, options 101, building blocks, transaction, option contract, shares, buy, sell, profit, option strike price, strike price, long option, short option, black scholes model, intrinsic value, extrinsic value

Id: 46KpKM5Vvec

Length: 23min 22sec (1402 seconds)

Published: Wed Sep 09 2020