FFO Options 9: Using Option Calculators

Dr. Scott BrownStock Options

IntroductionThere’s a certain formula that that’s used to calculate an option’s

premium.

The price, or “premium”, of an option is dependent on several variables:

Intrinsic ValueCurrent price of the underlying securityStrike price of the option

Extrinsic valueDays left to option expirationVolatility Interest ratesDividends

IntroductionIntrinsic value explains the relationship

between the price of the underlying security and the strike price of the option.

Intrinsic value tells us whether an option has any “real” or “true” value to it.

Only ITM options, whether calls or put, can have intrinsic value.

Introduction (example)Microsoft (MSFT) is at $27 per share. The

ITM call is trading for a premium of $3, but has only $2 of intrinsic value. “How’s that you ask?”

All you need to do is to subtract the call strike from the current price of the stock ($27-$25= $2). The $25 call is made up of $2 of intrinsic value and $1 of extrinsic value.

Intrinsic value lets you know what an option is worth if exercised at that moment in time.

Introduction(example)Extrinsic value is what’s left over after you subtract away

the intrinsic value.

Again intrinsic is the exercise value.

Let’s say that Intel Corp. (INTC) is still at $27 per share. The $25 call option can be exercised right now, which means we can buy shares of INTC for $25 per share. If we immediately turned around and sold the shares in the open market, we could get a minimum of $2 per share extra for our trade. That option then has $2 of intrinsic, or exercise, value.

ATM and OTM options have no intrinsic value.

Anatomy of Premium Premium arises due to market forces of supply and

demand.

This is because theoretical value doesn’t always match up to what the exchange floor is giving as a market price; usually due to high volatility.

An option calculator is also a great tool for computing “what-if” scenarios. You can change any input item on the left-hand side and see how it affects the options prices on the right-hand side. If you’re looking to buy or sell an option at a certain price, you can switch the underlying price, days to expiration, strike price, or volatility component until you find the right combination to give you your desired result.

Option CalculatorsThe Chicago Board of Options Exchange has

an excellent option calculator that is free. Imagine a stock trading at $109 and a call at

a strike of $80 where volatility is very high at 75% and time to expiration is 239 days, pays no dividend and average US. Treasury bill yield is 5%.

Option Calculators

Option CalculatorsThe call should be trading at $41.43What will the option be worth if volatility

drops to 25%; the stock price rises to $140; and time has passed to where a mere 32 days is left to expiration?

Option Calculators

Option CalculatorsThe call should be trading at $60.35

The stock rose $30 but the option value increased less than $20.

Option calculators are very useful when you are planning your option portfolio.

Remember that the equal allocation option portfolio model is best. Simply identify a handful of best momentum

stock candidates and spread your option bets equally.

Protect with puts when the VIX rises at 37.22 for 18 trading days and the S&P 500 price drops below the 200 day moving average.

Got Movement? “Option Values” are what we call the “Greeks”

The Greeks are by product outputs from the option pricing formulaGamma, vega and rho are mostly for professional tradersDelta and theta, are extremely important for us to know

The Delta tell us how much the option price will move In relation to a $1 move in the underlying security. Range from 0 to 1.00, with 1.00 being the highest correlation

with the underlying security. I’s quoted in percentage terms

Ex. If an IBM call option has a price of $4.50 with a delta of $.60, and IBM stock moves from $82 to $83, in theory that option should see its price move up $.60 to $5.10.

Theta tell us how much an option’s premium will decay on a daily basis.

Let’s analyze a situation…You buy a call option that expire in a few weeks, and the stock start moving nicely, yet your option contract isn’t gaining value.

What gives?

It’s most likely because you didn't buy an option with a large enough delta.

This occurs in the out-of-the money options and ones that are too close to expiration. They are cheap but don’t increase much in value when price move in favor.

Deep In The Money is BEST!

Delta’s RelevanceDelta it is a great gauge for telling you how

your option will perform. If you are a stock investor you use options to

gain more leverage with less capital.Sticking with options with higher deltas give

you the most bang for your buck. A high delta is the only way to assure your

long option profitability.

The Market Maker’s DeltaDelta also tells you how many futures contracts you

need to offset directional risk they had from option trades.Market makers always want to be delta-neutral,

which means that they have no directional bias and make money from changes in volatility.

The option market maker’s edge is vega.Your edge is delta when long and theta when short.

But you will only track delta. Time decay is easy; just sell options close to

expiration and you automatically make the most when selling options.

Disclaimer DISCLAIMER: THE DATA CONTAINED HEREIN IS BELIEVED TO BE RELIABLE BUT CANNOT BE

GUARANTEED AS TO RELIABILITY, ACCURACY, OR COMPLETENESS; AND, AS SUCH ARE SUBJECT TO CHANGE WITHOUT NOTICE. WE WILL NOT BE RESPONSIBLE FOR ANYTHING, WHICH MAY RESULT FROM RELIANCE ON THIS DATA OR THE OPINIONS EXPRESSED HERE IN. DISCLOSURE OF RISK: THE RISK OF LOSS IN TRADING FUTURES, FOREX AND OPTIONS CAN BE SUBSTANTIAL; THEREFORE, ONLY GENUINE RISK FUNDS SHOULD BE USED. FUTURES, FOREX AND OPTIONS MAY NOT BE SUITABLE INVESTMENTS FOR ALL INDIVIDUALS, AND INDIVIDUALS SHOULD CAREFULLY CONSIDER THEIR FINANCIAL CONDITION IN DECIDING WHETHER TO TRADE. OPTION TRADERS SHOULD BE AWARE THAT THE EXERCISE OF A LONG OPTION WOULD RESULT IN A FUTURES OR FOREX POSITION.HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL, OR IS LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. PS.  In our opinion, we believe, it may be possible, that heavy smoking and drinking may be hazardous to your health.  If you choose to smoke and drink while trading, The Delano Max Wealth Institute nor Dr. Scott Brown is liable for any damage it may cause.  If you slip and fall on the ice, we're not liable for that either.