Options Part 2

Below, are a few further components of options that you should become familiar with:

Strike Prices – The strike price is a fixed price for which an option can be purchased (call option) or sold (put option). Options are available in several different increments ranging from 1 point increments to 25 point increments. For example XYZr has strike prices starting at 90 and moving in 5 point increments up to 240. Therefore, you the trader could purchase the right to buy (call) or the right to sell (put) XYZ stock in a range of anywhere from $90.00 a share to $240.00 a share.

Months of Options – You will have a choice in determining which month of options you would like to use. Months available are classified into one of three cycles. So, if it were June 3rd you would be able to purchase options for June, July, August, or November; and you would also be able to purchase longer term options called “leaps” which are available for Jan of 08, and Jan of 09.

Expiration Date – Every single month, options expire on the third Saturday of the month. Since the market is not open on Saturdays traders use the third Friday of the month as there guideline. There are a few indexes however that expire the Thursday prior to the third Friday of the month. This is why it is essential to understand the vehicles you are trading.

Premium – This is the cost of the option.

Option Greeks – There are four main variables represented by Greeks letters that make up the value of an option. This is not meant to be a thorough evaluation of option Greeks as one could write an entire manual on this subject alone.

- Delta – This is the amount the option will increase in value per one point movement of the underlying value. Delta can also be thought of as a probability indicator. An option that has a strike price right where the stock is trading would have a delta close to 50. What this is saying is that the option has a 50 -50 chance of having value at expiration.
- Gamma – Gamma is the accelerator for Delta. It tells you how much the Delta will change after the first 1 point movement in the underlying.
- Theta – Theta is measurement of time decay. It tells you how much value is lost daily based off of the erosion of time.
- Vega – Vega is a measure of volatility in the option. The higher the volatility the more expensive an option can cost. Vega can also be thought of as a fear indicator. When there is uncertainty in the future people are more fearful concerning the outcome and hence, volatility will be higher. Conversely, when fear is low and people feel safe about trading a vehicle, the volatility is lower and the price for the option decreases.

Understanding the basics and effects of each of the Greeks can greatly enhance your trading; however, there are some interrelationships that you need to be aware of:

- All of the Greeks except for Delta are the most sensitive to the money.
- Gamma responds opposite to Theta (Time Decay). The more positive Gamma is the more negative Theta will be.
- As volatility decreases Theta (the value time holds in your options) decreases. As volatility increases Theta (the value of time in the option) increases.

Volatility-There are different forms of volatility in the marketplace. Volatility in its most basic form is uncertainty or fear concerning the marketplace. Volatility can be tracked by looking at the Vix, and VXN which measures the volatility in the S&P 500, and the NASDAQ.

Contract – When you are buying options you have to purchase them in units of 100. This is referred to as a “contract.” So, if you see that the price of an option is $3.50, this is the per option price. However, as the trader, you would have to purchase 100 options for $350.00 to buy 1 contract.

Intrinsic and Extrinsic Value – Intrinsic value is the amount of the option that represents real value. So if you are looking at a 135 strike price call option (which would give you the right to buy XYZ for $135.00) it is selling for the ask price of $5.40, or $540 dollars to purchase 1 contract. Since XYZ is trading in the live market for $139.00 then the 135 call option would have $4.00 dollars of real (intrinsic) value and the other $1.40 would be considered time value or extrinsic value. So to sum it up intrinsic value represents the real value in an option and extrinsic value represents the time value in an option.

ATM – At The Money options are the options that are the closest to where the stock is currently trading. If XYZ was trading at 139 then the 140 strike price “call” and “put” would be considered the At The Money Option.

ITM – The In the Money option represents the options that have real intrinsic Value.

OTM – The Out Of The Money options are the options which signify options that have no real value or intrinsic value. They only have time value.

The option also has a bid/ask spread. The “bid” price is the lowest price the market makers will consider for the price of the option. The “ask” price is the price the marker maker guarantees to fill you at. The range between the “bid” and “ask” is called the spread.

While this is a very basic overview of options it should help lay a foundation for the major components of options. We have briefly discussed the benefits of trading options but now let’s focus on just one strategy that a trader can utilize in the marketplace when using options.