Before Trading Options

As we’ve mentioned in the previous chapters, the option premium is the market price of an option contract.

The premium is derived from two sources: the intrinsic value and the time value.

The intrinsic value is affected by the difference between the stock price and the strike price, while the time value is affected by the days till expiration.

An option can fall into three groups: in-the-money, at-the-money, and out-of-the-money.

In-the-money option premium consist of intrinsic value and time value. Out-of-the-money premiums only consist of time value.

Traders would buy call options or put options based on their judgment on stock trends. And then sell it at a certain point in the hope of making a profit. Traders can also sell option contracts first and then buy later in hopes of making a profit.

However, trading options is more complicated than trading stocks. That's because trading options requires traders to be right about the direction of the stock price, and also understand how time and implied volatility affect option premiums.

First, the direction of the stock price.

If traders believe that the stock will rise, they can buy its call options or sell its put options. If traders think the stock will fall, they can sell its call options or buy its put options. However, the traders could suffer significant losses if they get the direction wrong.

Let's look at a hypothetical example of Rabbit Inc., which is currently trading at $38.

Suppose a trader buys a $40 call option at a premium of $2. The contract expires on March 18, so there are 30 days left till expiration. Since its strike price is higher than its stock price, this is an out-of-the-money option.

You may wonder why the trader would buy such an option with no intrinsic value.

That's because the trader believes Rabbit’s price has a chance to rise above $40 before the expiration date.

If the price of Rabbit's shares started to rise, its call option would stand a greater chance of going in the money and may drive up the premium. On the contrary, if Rabbit goes down or stays the same, it's less likely for its calls to move in the money and may cause the premium to fall.

The call premium may not necessarily go up along with its rising underlying stock. How much time it takes in the rise also matters. We know options' time value decays over time. To be more specific, in a limited trading range, the time value of the premium would fall over time.

Even if Rabbit's stock price rises to $40 on expiration, the call option might be worthless because it has no intrinsic value or time value.

Finally, implied volatility may also cause the premium to drop, though Rabbit's price moves up.

Implied volatility refers to how much the market expects the underlying stock to move. It is one of the factors affecting an option's premium.

If traders are long Rabbit's call options, an increase in implied volatility may drive up the premium. On the contrary, a decrease in implied volatility may cause the premium to drop.

To sum up, traders can pick out an option based on their judgment on the direction of the stock price, time, and implied volatility.

In the next chapter, we'll talk about implied volatility in more detail.