Monday, April 21, 2008

How options are priced.

Understanding how options are priced can greatly help you profit in today’s stock market. One of the biggest misconceptions about options is that they are 100% related to the stock’s price. This is not true, it is possible to buy a call option on a stock, the stock’s price goes up and the options price goes down.

That is because there are 2 different parts of an option. The first is called intrinsic value. This is simply the difference between the stock’s price and the options price. So if we buy a $90 call on a stock that is trading at $98 the intrinsic value is $8.

It would make sense for that option to be priced at $8. What you will find however, is that the option will be priced above its intrinsic value. The call might cost $9.5. The other $1.5 is the time value of an option.

This value gets its price based on how many days are left before the option expires. The downside of this is that as time goes by the lower the time value will go.

So, if that stock stays at $98 for a month the option price will have gone down even thought the stock’s price hasn’t changed. The time value will have probably gone down a lot by that time.

To make money on an option the stock must go up faster than the time value decays. Slowing down the decay of an options time value is just as important as finding a stock that is heading up. There are a few ways to do this.

1. Buy more time. Obviously an option 3 months away will decay at a slower rate than an option that will expire next week. Most professional traders will buy more time than they think they need to avoid time decay.

2. Buy an option with a lower strike price. The further in the money you buy an option the less time value and more intrinsic value it will have. Unfortunately the more in the money your option is the more you will pay for this option. But It helps to lessen time decay.

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