A detailed introduction to options and its components are discussed in our previous article. If you haven’t read that article, please consider reading it here. In this article, we will discuss some of the important terminologies that you should know about.
Implied volatility is one of the most widely used concepts for options traders. There are a couple of reasons why this is so. Firstly, it tells how volatile the market will be in the future. Secondly, it helps in calculating the degree of probability. This is very important in options trading since it gives the likelihood of a stock reaching a specific strike price at a certain time. Keep in mind that implied volatility does not give the market direction.
Types of implied volatility
There are different types of volatility, but options mostly focuses on two types of volatility. Namely the historical and the implied volatility. Historical volatility is the mathematical standard deviation of past stock price movements. It is mostly estimated on an annual basis. It keeps track of daily stock movements and gives the aggregate result. Whereas implied volatility (IV) is derived from the option’s price, and this price shows what the stock’s volatility might be in the future. IV is one of the constituents used in determining the option’s pricing model.
Trading using implied volatility
Implied volatility only gives an opinion about the stock’s potential move. It cannot be used in forecasting the market direction. If implied volatility is high, then traders think that the stock has a great capacity to make large moves on any side whether up or down. But if IV is low, then the stock might remain at the same price until expiry.
Strike price vs. Current price
A strike price is the one which is set by the seller of the option. This seller is called the writer. When you buy a call option, the price at which you can buy the stock after a period of time is known as the strike price. For example, Tesla Corp. is trading at $8. Now when you buy its call option with a strike price of $10, you have the right to buy the stock at $10 at expiration. The profit will be the difference between the stock price and the strike price. In the above case if Tesla moves to $15, then your profit will be $5. When a put option is purchased, the strike price will be the price at which we can sell the underlying security.
How to select the strike price
Selection of the right strike price is critical. Just because the premium of an option is negligible, you shouldn’t consider buying it. You are most unlikely to make money in this case. An important choice that we need to consider while selecting an option strike price is whether is it an ITM option, ATM option or an OTM option (more about these in the upcoming paragraphs). The second choice you should make is what is the maximum premium you are willing to pay for a particular strike price. Traders also use open interest (OI) of different strike prices to select the right strike.
Intervals in strike price
The intervals vary depending on the type of asset and market condition. Different countries use different standards for maintaining a fixed interval in strike prices. The strike price interval also depends on the volume at which they are traded. In the U.S. for lower-priced stocks, options are in the interval of $2.5. Higher priced stocks have strike price intervals of $5. Index options mostly have strike price intervals between 5 or 10 options.
Time Value of options
The time value of an option is defined as extra money a trader needs to pay over the current intrinsic value. In spite of this high price, traders buy because they are expecting the price to increase further. What this means is that if an option has months to expire, then we can expect a higher time value on it. If an option is expiring very soon, then its time value will be very little or nothing.
The difference between the option’s premium and the intrinsic value of the underlying asset is the option’s Time Value.
Time value = Option premium – Option intrinsic value
The options that are at the money (ATM) or out of the money (OTM) the premium will be as same as the time value because ATM and OTM options have an intrinsic value of zero. Among option strike prices, the ones that are deep in the money (ITM) the premium will only be the intrinsic value. It is the time on the option that will decide if it will be a profitable trade or not. Always consider buying options when there is enough time left for expiry.
The most widely used option Greeks are Delta, Gamma, Theta and Vega.
- Delta is defined as the amount by which an option price is expected to move based on $1 change in the underlying security. Calls have a positive delta which ranges between 0 and 1. While puts have a negative delta and ranges between 0 and -1. As expiry approaches delta for in the money calls becomes 1. Delta for out of the money (OTM) calls become 0 and will not react to a price change in the stock. Delta for in the money (ITM) puts approach -1 and for out of the money (OTM) puts approach -1.
- Gamma gives the rate at which the delta will change based on $1 change in stock price. So if delta gives the “speed’ at which the option prices will change, “gamma” can be considered as the “acceleration”. Gamma is the best tool to check the responsiveness of the option price for a movement in stock price. Option buyers require high gamma and option sellers need low gamma.
- Theta is the amount by which the value of puts and calls will decrease for a single day change in the time to expiry. Out of the money (OTM) options have lower theta than for at the money (ATM) options. In options, the passage of time is critical to the option’s time value. At the money (ATM) options have high time value built into the premium.
- Vega has a direct relationship to implied volatility. For a one-point change in implied volatility, the amount by which call and put options change is indicated by Vega. Vega will not affect the intrinsic value of options and affects only the “time-value”. This is because when implied volatility increases option value increases. Vega suggests a potential for stock movement.
Now that you know the terminologies involved in Options trading, you should easily be able to understand the upcoming topics regarding options.