Understanding Option Prices - COMPLETE BEGINNERS GUIDE (Part 3)

[Music] in chapter one we used the insurance analogy to explain options to you and we're gonna go back to that analogy quite a bit in this chapter because thinking about options as insurance is the best way to understand the way they are priced now there are three factors that will cause an options price to move around each day once you understand how these three factors affect option prices on a daily basis we will be able to dive into different strategies we can use to take advantage and profit from option price movements and you know that's where the fun starts but we have to lay the groundwork first and focus on understanding these three factors number one the price of the underlying stock number two time to expiration and number three the volatility of the underlying stock first let's talk about how the underlying stocks price will affect the price of its options let's think back to the basic definition of a put option buying a put option gives you the right to sell stock at an agreed upon price on or before a particular date and of course the agreed upon price is determined by the strike price right now you can see twitter stock and its options that expire in 28 days let's say you own 100 shares of twitter stock at 18 per share you could buy the 18 strike put option and that would be like buying full coverage insurance right if for some crazy reason twitter tanks then your put option would allow you to sell your shares of stock at 18 per share right where you bought it even though the current market price is much lower than that and looking at the option pricing you can see that it would cost around 159 for the 18 strike put option and of course multiply that by 100 and the cost of one contract of this 18 strike put option would be about 159 dollars now if you were to buy the 16 strike put instead you can see that it would cost you much less money it would cost around 75 dollars for one contract the reason it's cheaper is because it would only ensure 16 per share worth of your investment rather than the full amount of 18 per share now let's look at an entirely different example let's say you own the 120 strike call option on stock xyz you don't own any stock you just own the call option and this call option would of course give you the right to buy shares of xyz stock at 120. so what if the current stock price is at 125 per share well if the current stock price is at 125 and you own an option that gives you the right to buy stock at 120 then that option is going to be worth at least five dollars right because if you exercise the option you would have an immediate five dollar per share profit in this scenario we would refer to this option as being in the money because it has value it allows us to purchase the stock at a discount to the current market price so again this option is referred to as being in the money now one more scenario again let's say you own the 120 strike call option but this time the stock is much lower than that it's currently at 115. if you own an option that gives you the right to buy stock at 120 but the current stock price is below that at 115 assuming there's no time left expiration how much is this option going to be worth in this case right it's going to be worthless because who in their right mind would want to exercise their right to buy stock at 120 when they can just simply purchase it at its current market price of 115. in this scenario we would refer to this option as being out of the money because the call option strike price is above the current stock price and therefore does not allow us to purchase the stock at a discount again this is referred to as out of the money now i know this seems like a lot to keep up with and a lot of information to digest all at once and of course we're going to recap all of this again at the end of the chapter for you to take notes on the cool thing is if we look at an option chain you can see that the in the money and out of the money options are highlighted the in the money calls inputs have a bluish shaded background and the out of the money calls inputs have an empty or black background so just one more time in the money calls are calls with a strike price that is less than the current stock price and the out of the money calls are calls with a strike price that is greater than the current stock price and for puts it's the exact opposite now this is where it will start to come together you'll notice that the further in the money an option is the more expensive it is this is because if an option allows you to purchase the stock at a bigger discount it's going to be more valuable than an option that only allows you to purchase the stock at a small discount now here's the thing stock prices are always moving so if you own a call option and the stock price goes up then that call option will increase in value because it is becoming more and more in the money let me repeat because this is important if a stock's price rises then that stocks call options will increase in value and if you own a put option and the stock price falls then that put option will increase in value now if you buy an option today and are wondering what it will be worth at the expiration date it will simply be worth the difference between the stock price and the options strike price to put it simpler the option's value will be determined by how far in the money it is this is also referred to as intrinsic value of the option an option will simply be worth its intrinsic value at the expiration date to demonstrate this let's look at the options that are about to expire in twitter so these options basically have no time left on them the stock is currently trading at 1809 and if we look at the 17 strike call we can see that it's worth a dollar five by a dollar fourteen so around one oh nine the reason is because the 17 strike call would allow you to purchase the stock at a discount of a dollar and nine cents and if we look a little further in the money you can see the 16 strike call is worth around 209 it says 215 on the screen because it's so deep in the money and the bid ask spread is kind of wide but its actual worth is around 209 because it would allow you to purchase the stock at a discount of two dollars and nine cents per share and remember if an option is out of the money then it will be worthless at the expiration because nobody wants to purchase stock at a higher price than the current market value and similarly out of the money puts will also be worthless because nobody wants to sell stock at a cheaper price than what it's worth and you can see that on these options here all the out of the money options are worthless so just to recap real quick at the expiration date in the money options will be worth the difference between the strike price and the stock price and all out of the money options will be worthless but let's look at the options that are not yet about to expire you can see that even the out of the money options still have value so if all out of the money options will be worthless at the expiration date then why do they have value now this leads us into our next point which is time to expiration let's talk about how time will affect an options price we've talked about how options are basically insurance and of course you have to pay money for this insurance now the thing about insurance is you don't get to just pay a one-time payment and have insurance forever you have to pay month after month to keep your insurance so the longer you have it the more money you will have to pay options are the same way they have expiration dates for the exact same reason you have to pay monthly for car insurance if you want to insure your car for six months it might cost you six hundred dollars but if you want to insure it for 12 months it might cost you 1200 in the exact same way an option with 60 days to expiration is going to have a higher price than the same option with only 30 days to expiration in the last section you learn about in the money and out of the money and you learn that out of the money options are options that have a strike price that does not allow you to purchase or sell the underlying stock at a better price than the current market price so therefore out of the money options are worthless now this is only true if there is no time left on the option let me explain right now you're looking at twitter options that have zero days left they expire this evening after the market closes and you can see that the out of the money options are at zero now let's look at the options that still have time left until they expire we're going to look at the options with 28 days to expiration you can see that the out of the money options with 28 days to expiration have value but if they won't have value at the expiration then why do they have value now the answer is because stock prices move and if there is still time left until expiration then there is still a chance that the out of the money option could become in the money so the reason these out of the money options have value is because there is still time left for the stock to move around think of it this way when you purchase car insurance is it going to be worth the price you paid well we don't know right because we don't know if you're going to get into a crash it could end up being worthless or you could get into a crash and you'll be very happy that you had the insurance now i realize that car insurance is required for all drivers even if you know it's overpriced but the analogy still stands now you can see that the further out of the money an option is the cheaper it is that's because the likelihood of it being of any value is less than an option with a strike price that is closer to the current stock price right this stock is more likely to get to 20 per share within the next 28 days than it is to get to 25 dollars per share because it would have to make an extremely large move to get to 25 whereas it would only have to make a small move to get to 20. so therefore the 25 strike call option will not cost that much money because it isn't very likely that it will be of any value at expiration now you see the prices of these options with 28 days to expiration again let's take a look at what these option prices will look like with zero days to expiration all of these out of the money options are worthless and the in the money options are worth the difference between the stock price and the strike price this is because since there is no time left there is no time value left on these options this is also referred to as extrinsic value extrinsic value refers to the amount by which an options price is greater than the intrinsic value and intrinsic value refers to the in the money portion of that option's price okay so that may have sounded a little confusing so let me just show you a quick example remember we mentioned that these options that expire today don't really have any extrinsic value so let's again go back to the options with 28 days to expiration check out the 17 strike call option with 28 days the price of this option is 220 and the current stock price is 18.09 so this 17 strike call option is a dollar and nine cents in the money so its intrinsic value is 109 and the extrinsic value is just whatever is left over so in this case the extrinsic value is 111 and remember at the expiration date there will be no extrinsic value left on the options the value of this option at expiration will be whatever its intrinsic value is so in practice what does this actually mean for us well let's say we bought this call option right now at 220. we know that if twitter stock doesn't move and just trades sideways for the next 28 days then this option is going to gradually go from 220 down to 109 and we learned in the last chapter that option prices have a multiplier of 100 so in this case we paid 220 dollars and sold it for 109 dollars so our net loss would be 111 dollars and the stock didn't even move for us to have made money on this call option twitter stock would have had to move high enough for the intrinsic value to exceed the premium we paid for the option so for example we paid 220 for the 17 strike call for us to break even on the trade at expiration the stock would have to be at 17 plus 220 which comes out to be 1920. twitter is currently at 1809 so it would have to move all the way up to 1920 for us to just break even that's why we kept saying to keep watching before you start buying calls on every stock you think is going to go up and puts on every stock you think is going to go down because even though it costs much less than trading the shares of stock you're going to have time decay against you so not only will the stock have to move in your favor it will have to move in your favor a significant amount for you to even break even options are constantly decaying as time passes this is exactly why we don't trade options in this way we never buy options as a way to guess direction of the underlying stock we actually trade them in a way to take advantage of this time decay and you're going to learn these strategies later on in this course now one thing i want to quickly mention to avoid confusion is that an options extrinsic value or time value is gradually decaying so if you buy this option today and twitter moves up to 1920 tomorrow then you're going to have a pretty decent profit because there will still be time value left on this option so your breakeven that we determined of 1920 that is your break even at the expiration date if that confused you don't worry about it we're going to touch more on this topic very soon but i just wanted to mention that to clarify that you don't have to hold an option all the way to its expiration date we are actually able to open and close the trade anytime before the expiration date now let's recap what you've learned in this section expiration dates options have expiration dates for the same reason you have to pay monthly for car insurance with that being said you don't have to hold an option all the way to expiration if you own an option then you can sell at any time before expiration at the current market price of the option and more time equals more money if you buy an option with 60 days to expiration it's going to cost you more money than if you buy an option with only 30 days to expiration you'll also learn about intrinsic and extrinsic value intrinsic value simply refers to the in the money portion of an options price and extrinsic value is just anything left over extrinsic value can also be referred to as time value and remember if an option has no time left to expiration meaning it's about to expire then it's going to have no time value left on it it will simply be worth whatever its intrinsic value is and lastly option prices are always decaying due to the passage of time so if you are buying options you will be fighting this decay which is why we recommend you to finish this entire course before making your first option trade so you can learn other strategies to allow you to put yourself in a position to profit from this time decay it's extremely powerful once you learn how to do this let's talk about volatility most option traders learn what you learn in the first two sections and they think that's enough they just completely ignore this third factor and then they wonder why they can't figure out how to make any money trading options so listen up because volatility is equally as important as the other two factors if not more important especially when learning how to make money trading options you have to understand volatility and it's actually not that complicated so what is volatility volatility is simply the magnitude of a stock's price swings if a stock has high volatility then that means it has large price swings and if a stock has low volatility then that means it has small price swings now think about this if you own a stock as an investment then that stock's volatility is a good measure of your risk right if a stock has high volatility and it makes large price swings then you are going to be exposed to bigger losses on that stock investment so high volatility equals more risk for the stock investor and since there is more risk involved options will be more expensive i know you're probably sick of the insurance analogy by now but let's think of options as insurance again if you buy an option as a way to protect your stock investment you are paying the option seller to take on your risk and if your risk is higher then why would the option seller not demand more money right if they are assuming more risk then they are going to want to be paid for that let me explain let's say you are an insurance company and you are providing life insurance for two different people the first person is overweight smokes a pack a day and has a serious medical condition and the second person is healthy exercises regularly and has no signs of any life-threatening medical conditions who do you think is going to have to pay more for life insurance exactly the person who is at more risk of dying now think of this person as a stock with high volatility and this person as a stock with low volatility so a high volatility stock is going to have more expensive options just like a very unhealthy person is going to have to pay a ton of money for life insurance and a low volatility stock is going to have cheap options in the same way that a very healthy person isn't going to have to pay that much for life insurance now let's take a look at a real example i found two companies who have stock prices that are right around the same price and we have the option chain of each stock pulled up side by side for you to see so on the left side you can see ewz and on the right side you can see fxi the difference in price between the two is only six cents so basically nothing and then of course the options displayed on your screen have 28 days to expiration so the same price of the underlying stock and the same amount of time to expiration now check this out the implied volatility or in other words the expected volatility for ewz over the next 28 days is plus or minus 244 so in other words it's expected to trade in a range of two dollars and 44 cents over the next 28 days now if you look at fxi on the right side you can see that it's implied volatility or in other words it's expected range that it will trade in over the next 28 days is a dollar and 89 cents now don't over complicate it the only reason i show you these expected ranges is simply just to demonstrate that ewz is expected to have more volatility than fxi or in other words ewz is expected to make a larger move over the next 28 days and fxi is expected to make a smaller move so same price of the underlying same time to expiration but different implied volatility check out the 37 strike put option on ewz the price of this put option is around 85 cents but if you look at the 37 strike put option on fxi you can see that its price is only 54 cents this is a demonstration of how a stock that is expected to have high volatility is going to have expensive options and a stock that is expected to have low volatility will have cheap options and this doesn't just apply to the 37 strike put you can actually see that the puts and calls at every strike are more expensive on ewz than on fxi okay you get it high implied volatility equals expensive options and low implied volatility equals cheap options simple enough high risk means expensive insurance and low risk equals cheap insurance now let's talk a little bit about what this would actually mean for your trading well just like a stock's price can go up or down its implied volatility can also go up or down if implied volatility goes up then the options both calls and puts will get more expensive and if implied volatility goes down its options will get cheaper but you might be wondering what the heck would cause implied volatility to go up or down well here's the thing the implied volatility of a stock is actually determined by its options prices not the other way around okay let me say that again in a different way the option prices are actually what tell us the future expected move also known as implied volatility of a stock it's kind of like the option prices are what they are and those prices spit out the implied volatility number and that tells us the expected move of the stock okay so that doesn't really answer the question and maybe your head is spinning at this point but let me ask you what causes a stocks price to go up or down could be a huge number of things but it simply comes down to supply and demand if there are a lot of buyers the stocks price will go up and if there are a ton of sellers the stocks price will go down options are the same way tons of option buyers would cause the options to get more expensive and tons of option sellers would cause an option to get cheaper then the options prices would tell us what the implied volatility is so again what would cause the implied volatility to go up or down well really it's just a question of what would cause a lot of buyers for options and what would cause a lot of sellers to answer this question let's think of options as insurance again what would cause a lot of demand for insurance fear of the unknown when investors are scared and feel like they have a lot of risk they might start buying options to protect their portfolios because they expect a lot of volatility and all of these option buyers would of course cause the options prices to go up and therefore the implied volatility number would also go up which makes sense right because the investors are expecting a lot of volatility so in essence implied volatility is kind of like a fear gauge for the market now as a newbie if that doesn't make your head spin and make you want to give up then i don't know what will if that didn't really make sense don't worry because fortunately it doesn't really matter right now just understand that if a stock's implied volatility goes up then that means its options are getting more expensive and if a stock's implied volatility goes down then its options are getting cheaper this is a huge part of our trading strategy because implied volatility is actually very predictable whereas stock prices aren't that predictable so alright guys that's it those are the three factors that affect an options price now let's check out some real examples to see if we can put what you've learned so far into practice so again we're looking at twitter options and these options have 28 days to expiration let's use a tool on the thinkorswim platform called theotool to try and estimate how an option you own might be affected by each of these three factors you learned about now this is just for demonstration purposes and you don't need to understand how to use this tool or even how to use this platform at all right now it's just to help you understand what the price of these options will do in different scenarios and actually let's make this a little easier to see we're going to set this up to only display one option strike and alright so we have the 19 strike option showing now let's say we want to make a bet that twitter stock is going to go much higher over the next 28 days we could do this by buying a call option so that's what we're going to do for this example we're just going to say we bought one contract of this 19 strike call option and you can see the current price of this option is around 128 so multiply that number by 100 and the real cost of this option contract is 128 dollars now whether or not this trade will be profitable on a day by day basis will be determined by all three of these factors you just learned about so first we're going to look at these factors individually you learned that all out of the money options will be worthless at the expiration date so for our very first scenario let's say the stock doesn't move and implied volatility doesn't change the only thing that happens is time passes so the only thing we're going to change is this date that you see here you can see that as each day passes this options price is decaying and gradually going to zero so if this scenario were to happen you would lose the entire price you paid for the option which was 128 dollars okay now let's say the price of twitter goes higher immediately after entering the trade so no time passes and implied volatility doesn't change so let's say the stock is instantly one point higher you can see the price of this option is now at 179 now let's say it went up another point so it's up a full two points from where you entered you can see that the options price is now at 238 so if you bought the option for 128 and sell it for 238 then you made 110 dollars on the trade now just a quick side note you may wonder why the option went up 110 when the underlying stock went up too you're going to learn why this is the case and also how to estimate this type of thing while trading options in the option greeks chapter okay so there's one more factor that affects an options price on a day by day basis and that is the daily changes in the underlying stocks implied volatility so for this scenario let's say the stock doesn't move and no time passes either the implied volatility just magically jumps up by 25 you can see that the call options price went from 128 to 179 so you would have turned your 128 dollars into 179 dollars for a total profit of 51 dollars now the reality is there will rarely ever be a time when only one of these factors changes without the other two also changing the underlying stocks price and implied volatility will constantly be changing on a daily basis and time is always passing so now let's look at a few scenarios where all three of these things are affecting the options price at once so in this scenario let's say that just one week has went by and the stocks price has risen by a dollar and fifty cents per share you can see that the price of this option we own is now at 184 so that means we've turned our 128 dollars into 184 dollars for a profit of 56 on the trade in this scenario the stocks price went up quite a bit and time decay well it hurt us of course you know it's always going to hurt us if we are buying options but it didn't hurt us that much so we were still able to make a pretty nice profit okay now in this scenario let's say the stock still went up by a dollar and fifty cents per share but this time instead of doing so in one week it took three weeks so we'll move the date forward three weeks and you can see the options price is 123 so our total loss in this scenario is 5 dollars so the stock went up which helped us of course but it took too much time to go up so the time decay was too much here for it to even matter that the stock went in our favor and this resulted in a small loss on the trade okay now let's say one week goes by the stock goes up by 50 cents per share and implied volatility goes down by 10 percent you can see that the options price is now 112 resulting in a 16 loss so the stock went up like we wanted and it didn't take much time to do so but in this case the implied volatility went down so the drop in implied volatility plus the little bit of time decay that occurred more than cancelled out the fact that the stock price went up which caused us to lose money okay just one more scenario this time let's say the stock doesn't move implied volatility goes up by a full 25 percent but a little over three weeks has gone by and there are now only four days left until expiration you can see that the price of this option is now 53 cents resulting in a loss of 75 dollars so the stock didn't move at all volatility went up huge which is exactly what we would want to happen but time decay more than canceled out the huge spike in implied volatility which caused us to lose money on this trade you'll notice that in most of these scenarios we lost money and in most of these scenarios the stock went in our favor so you might be thinking why am i learning how to trade options again well remember in all of these scenarios we bought this option and we've repeatedly mentioned that this is our least favorite way to trade options in fact we don't ever trade options in this way the bottom line is there are two sides to every trade and you can take either side so alright guys hope you enjoyed the video if you did make sure to click the like and subscribe button below and also be sure to check out our three free video series by clicking the link in the video description below these videos will help your trading tremendously and they are completely free all you have to do is click the link input your email and we will send you the three videos so i will see you there [Music] you

Channel: Sky View Trading

Views: 824,850

Keywords: Option prices, options prices, understanding option prices, option prices explained, option pricing, options trading 101, options trading explained, options for beginners, option prices for beginners, options trading, stock options, understanding options trading, introduction to options, stock options trading 101, stock options explanation, what are options, how to trade options, options trading basics, sky view trading review, option pricing 101, option pricing explained

Id: 1u4sdf-3twQ

Length: 32min 1sec (1921 seconds)

Published: Tue Jun 22 2021