I have noticed that options price changes according to the changes happening with it underlying eq stock. So can I trade in a stock option purely based on price movements in its underlying stock ??
- Need a nice & clear explanation !
I have noticed that options price changes according to the changes happening with it underlying eq stock. So can I trade in a stock option purely based on price movements in its underlying stock ??
Though stock price is one of the factor that affects stock option price, it is not the only factor that affects it and hence should not be traded just on that.
Will try to explain the reason here but it is suggested to refer to authoritative sources for complete knowledge
Suggested Reading -
-Getting Started in Options by Michael C. Thomsett
-McMillan on Options by Lawrence G. McMillan
-Options, Futures, and Other Derivatives by John C Hull - one of the best books for option pricing models explanation.
Coming back to questions
Basically option is a simple contract which gives one an option to buy/sell the underlying asset at any time on or before the specified date i.e. option expiry date. So if one is bullish then one may buy call options or if one is bearish then one can buy put options. One may not exercise the option but in that case will loose the full premium paid.
E.G. (all figures are for illsutrative purpose only) one is bullish on reliance which is currently trading at say 1000 rs. One expects it to go over 1100 rs over period of next one month. If one wants to buy 100 of stock than one has to come up with 100000 rs upfront. Instead one can buy 1050 strike price call option which say is currently available for a premium of 50 rs. So in this case one will have to pay only 5000 rs.(assuming contract size of rs 100) and still enjoy similar profits.
Having said that lets understand what are the factors that influence the price of an option
Underlying price - mostly as the price of underlying increases price of the call option increase while price of put options decrease. And opposite happens when the price of underlying decreases mostly call options become cheaper while put options become costlier. (there are scenarios where this may not happen because of erosion of time value and volatility cool down - will come to it later).
e.g if Reliance goes from 1000 to 1050 then 1050 call option price may go from 50 to 75 while 950 put option may reduce from 50 to 25.
Strike price - As the underlying price increases, intrinsic value of call options increase which increases the option price for âin the moneyâ, âat the moneyâ and some âout of moneyâ call options (Some out of money call options may actually if time value erosion and volatility cool of is more than increase in intrinsic value). At the same time intrinsic value of put option decreases which decreases their premium. Opposite happens when underlying price decreases.
e.g i.f. Reliance goes from 1000 to 1050 then 950 call(in the money) may go from 110 to 150, 1050(out of money) call may go from 50 to 75 while 1500 call (deep out of money) may actually reduce from 10 to 8.
Volatility - it refers fluctuation in the underlying price. If the price moves in wide range then it is more volatile and options (both call and put) will be costlier while if price moves in narrow trading range, then options will become cheaper.
As the volatility increases, options get costlier everything else remaining same while they become cheaper when volatility cools off.
e.g. If reliance daily movement is about 100 rs then 1050 call may be around 50 rs while if the daily movement is around 50 rs then 1050 call may be available at around 25 rs. In both the scenarios reliance is trading at 1000 rs.
There are two types of volatility historical and implied. In the calculator you are referring to it is implied volatility which is derived from the option prices (rest all remaining same). Hence there is a radio button for volatility or premium. You enter one of them and it will calculate the other.
Time Until Expiration - obviously, the further is this the higher the probability of option becoming profitable. Hence Far Month options are costlier than Near month options. As the expiration approaches the time value will decrease and option will become cheaper everything else remaining same. This is what I had referred to as Time Value erosion earlier.
e.g. While Reliance is trading at 1000 - 1050 July call option may be available for 100 while the August 1050 call may be priced at 200. Also 1050 July call price may decrease from 100 to 50 as we approach 31 July (expiration date) if Reliance is still trading at 1000.
Interest Rates - though this donât affect day to day option pricing, but they are still required to calculate the premium. Why? Reason being difference between the actual value of the asset and premium paid can be put in fixed deposit which will earn interest. In our e.g. 95000 rs can be put in FD. Hence in the high interest rate scenarios options are costlier while they are cheaper during low interest scenarios. Since interest rates donât change day to day they donât affect day to day option price movement.
6)Dividend - they have the smallest role in option pricing. When the underlying instrument becomes ex-dividend, calls price will decrease while puts will become costlier. This actually may not happen if the dividend amount is negligible and most of it is already factored in.
Given all these factors, how does one calculate what premium one should pay. This is where pricing models come in. There are two main pricing models - Black-Scholes Model and Cox-Rubenstein Binomial Option Pricing Model. This models calculate option price (also known as Theoritical Value or TVal in short) given all the above factors.
So what is option calculator - it is an utility based on the above models which helps in calculating options TVal (when volatility is known) or implied volatility (based on current option premium) given all other factors.
So how to use option calculator - just feed in the required parameters. Enter premium to get the implied volatility or volatility to get TVal.
Hope this answers your question.
Nice tutorial on investopedia http://www.investopedia.com/university/options-pricing/
Options are not like equity stocks or futures.
They spring back and forth based on various parameters.
For example take a stock with lot size 2000.
You can see when underlying stock price say at 300 and option price as 13.5 (option value 13.5x2000=27000) and on the same day you can see the underlying stock at same 300 but option price as 11.3 (option value 11.3x2000=22600), this is quite possible.
So do not just trade options based on underlying price.
hey Ravi, i donât think itâs a good idea to trade in options by just depending on price movements of the underlying stock. thing is, you just CANNOT anticipate whether the price of the options contract will have a direct correlation or an indirect correlation with the price of underlying stock or index.
An important concept to know the correlation between options price and the underlying price is by understanding how Option Greeks work. . They represent the sensitivity of the price of the option to a change in the underlying. Itâs important for an option trader to understand how different factors play their role in determining the price of an option contract.
Here are four primary Options Greeks you can start with -
if you want to understand each of them in more detail, hereâs the âDecoding Option Greeks: Delta | Theta | Vega | Gammaâ blog I recently published on LearnApp
Do cheggit out and let me know if it help
You think he is waiting from past 8 years ?
8 years later
Are you searching for relevant topics manually and replying or am I talking to a bot
lol, hoping it would be useful information for someone searching for a similar query =D
helllllooo GB, first of all - not a bot
and yea, Iâm new to the forum world and hence kinda exploring a few stuff