NSEBSECOMMODITYNASDAQNYSEFOREXINDICESAMEXUSA NSE Futures NSE Options More...

Basics of Options. Call, Put and how to calculate Intrinsic value of CALL and PUT

Basics of Options. Call, Put and how to calculate Intrinsic value of CALL and PUT

The core basic of options is:
You and someone else agree to buy or sell a stock at a "certain price" in the "future", instead of the price at which the stock is trading "then."

As a buyer, you pay a PREMIUM to the seller of the option.
Premium is made of 2 things:
1. Intrinsic value (real value)
2. Time value (keeps going down daily)
Time value becomes zero at expiry date

All the options that do not have intrinsic (real) value in them are called "out-the-money" OTM options
Options that have Intrinsic value are called "in-the-money" ITM option

Calculating ITM or OTM is different for CALL and PUT. See below

At the time of expiry, you as a "buyer" want the option to be an ITM option
As a seller, you want it to be an OTM option

CALL & PUT:

First as a buyer of CALL (you):
Current price of #GOOG is 942, called SPOT price

If you think that price of GOOG is going to move "up", you buy a CALL of GOOG at a price you choose, called STRIKE price
Remember, if you think prices will move "up", you buy "CALL"

This chosen strike price can be lower, higher, or same as current spot price, your choice.
Premium will differ for each. Why? Because one of those will have "Intrinsic" value in it, and others won't.

Finding Intrinsic value of a CALL option, formula:
Value = SPOT - STRIKE

If value is a negative number, then its considered zero.
In our example, consider the following STRIKE prices

Strike = 950
Value = 942 - 950 = 0

Strike = 900
Value = 942 - 900 = 42

Look at the formula for premium again

Premium = Time + Intrinsic Value

Based on this we know that CALL of 950 STRIKE will be cheaper than CALL of 900 Strike

This concept is what we want to benefit from.
We want to buy a CALL which has zero intrinsic value right now, but which will later have intrinsic value in it. The more the better.

Most important thing to remember:

Every single day that passes, time value in the premium will keep falling.
Why is this important?
Because if Time value falls "more" than the intrinsic value that came in, then the total premium will fall...

So when you bought the CALL:
Value=0
Time=10
Premium= 0 + 10 = 10

5 days later:
Value=2
Time=5
Premium= 2 + 5 = 7

Notice how time value fell faster than the increment in the intrinsic value

Time value falls everyday, rate differs. Its not a fixed rate of fall...
The longer you hold an option, the higher chances that time decay will chew up your profits.

Common mistake new option traders do is that they choose a strike price which is very very far away from spot price. They do this because premium of such OTM options is very low.
This also means that they have to hold the option longer, and time decay will do what it does best. Eat up profits...

Now as a buyer of PUT (you):
If you think prices of #GOOG are about to fall "down", then you buy a PUT option
Remember, you buy a PUT option if you think prices will come down

Calculation of Intrinsic value for PUT:
Exact opposite of CALL

Value = Strike - Spot

Spot is current price of stock
Strike is price you chose.

Same example of GOOG, consider following strikes:
Current spot price is 942

PUT strike of 950
Value = 950 - 942 = 8

PUT strike of 900:
Value = 900 - 942 = 0

Again, if value is negative, then its considered as zero
Based on our formula of premium, we know that PUT of strike 950 is costlier.
Remember this was cheaper in case of CALL

Time decay plays the same role here too.
We too want the same thing. Buy a PUT that has no intrinsic value in it, but is expected to have some in the future. The more the better

So far you know:
1. In case of CALL you make profit if SPOT is higher than STRIKE
2. In case of PUT you make profit if SPOT is lower than STRIKE
This is true for "buyers" of options

As a seller of options:
You make profit if "buyer" loses.

So as a seller:
1. In case of CALL you make profit if SPOT is "lower" than STRIKE (same as PUT buyer)
2. In case of PUT you make profit if SPOT is "higher" than STRIKE (same as CALL buyer)

At expiry, if the option is OTM for buyer (no intrinsic value), then seller of option gets to bag the premium that was paid to him by the buyer. Profit of seller.
So as a seller you want the option to go OTM for the buyer
As a buyer, you want the option to be ITM for yourself

Remember that as a seller, the max profit can only be the premium that was paid to you.

As a buyer, the max profit can be the intrinsic value that the stock can get. Could be huge.

As a seller, the max loss can be huge if option becomes ITM for buyer and accumalates a lot of intrinsic value
Your loss will be the amount of intrinsic value it got in, "per share"
So as a new trader, avoid selling options because this can really wipe out your entire money in just one single trade...

Maximum loss for buyer is the premium you paid when you purchased the option. Limited.

Sellers can reduce the loss by actually holding the equity they are selling in the options market. This is called covered option writing.
In this case, the loss is really limited, and also opens a lot of other opportunities for building option strategies.

Best time to trade options is near expiry, and there are two reasons for this:
1. Premium is low because time value has reduced too much. So if you make a loss, it'll be less.
2. You pretty much have a sense of where the stock might be heading. Not always, but generally.

Remember, never choose a strike which is too far away from spot. Chances of this getting intrinsic value are less, and time decay will keep reducing the cost of the option, thus building up your losses.

Buyer of an option can also profit by "squaring off" an option he bought earlier, without waiting till expiry.

Same example of #GOOG
Current spot is 942
Time left for expiry is 10 days, and lets say that time decay is 1 per day

You think its going to go up.
You "bought" a CALL option, strike of 950
Premium = Value + time = 0 + 10 = 10 dollars

3 days later:
Spot moves up to 955
5 dollars of intrinsic value came in.
3 days of time value went out of 10 we had earlier
Premium = 5 + 7 = 12
We square off and take our 12 dollars home.
That's a 20% profit in 3 days...

Square off means that someone else bought the option from us. Note we are not the seller, we just transferred the contract to someone else.
All options are just contracts, a promise to do something in the future...