Stock options offer a wonderful way for you to play the market with little risk but high potential for profit. Rather than buying the actual stock and taking the risk of it tanking, you simply buy the option to buy or sell it. This gives you a fixed price that won’t change no matter what the underlying price does.
Understanding stock options is quite challenging. Many mathematical models have been constructed and applied to the study of how options operate. However, you can get a good grasp on how they work and how their value is determined by looking at 5 key factors.
The underlying price has the biggest effect on a stock option premium price. With options, there are ‘calls’ (options to buy) and ‘puts’ (options to sell). Basically, call option value follows the price of the underlying while put goes against.
This means that if the market price increases, the price of the call premium increases and the put option decreases. Likewise, when the market price decreases, the price of the put option premium increases and the call option decreases.
If you buy a call option and the price of the underlying goes down, it will lose you money if you exercise it. It’s best to let it expire without taking any action. However, if the price goes up, your call option becomes more valuable.
Put options work the same way but in reverse. When the price goes up, your put option becomes more valuable. When the price goes down, your call option’s value decreases. So, it’s good to buy call options when the market price is down, and exercise them when it’s up; and vice versa for put options.
Volatility refers to the movements of the market, or its swings up and down. When you buy options that are ‘at the money’ (close to the underlying’s value), they’re more vulnerable to volatility. Higher volatility means more risk but it can also mean more profit. This is why higher volatility means higher premiums.
Call options are generally less affected by market fluctuations. This is because their premiums rise over time, which leverages the risk.
Every option has a set expiration date and the closer it gets to this date, the lower its premium becomes. This is because when you buy short (less time remaining in the life of the option), there’s less chance of the option being profitable. However, this also depends on where the option’s value is sitting. If it remains more or less in-the-money throughout its life, you can expect it to hold its’ value as it approaches the expiration date.
Dividends do not have a great effect on most options but their impact can be felt. If an option’s dividend goes up, put options are worth more while call options are worth less; but, keep in mind that this may be such a small amount that it’s not worth considering.
Interest rates also don’t have as serious an impact as volatility or underlying price except in certain situations. When interest rates are going up, it drives up call premiums and drives down put premiums. This is because it’s cheaper to buy the option than the actual stock; the buyer is willing to pay more when interest rates are rising because it means it’ll probably be a good return on their investment.
When interest rates are high and rising, it’s a good time to exercise a put option early if it’s an American option (American options let you exercise before the expiration date if you want to; European options don’t). The interest earned from the proceeds of the sale will be high.
There’s a lot more to stock options than just these 5 factors, but if you understand basically how they work, it’s a great start in profiting from your options trading.