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Call Option Trading – “Call” The Shots

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Introduction

 

 

Call options are just one type of trade that investors and traders can conduct to either profit from or help facilitate the growth of their overall portfolio. But it is important to understand what call options are, what they consist of, and how to determine the price that one must pay in order to buy or write a call.

And in this lesson, you’ll learn more about call option trading, the components that make up the premium, and how they impact the price of an option.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Call Option Premium: Good “Call”

 

 

A call option is a contract that gives the buyer the right to buy one hundred shares of stock at a set price, on or before a certain date.

While most contracts represent one hundred shares of stock, there are some that represent as few as ten shares.

A call option can be used as a substitute to buying stock. By purchasing the call option, you purchased the right to buy the stock at a set price, known as the strike price.

However, you only have this right for a set period of time, because the call option has an expiration date.

As the underlying stock price rises in value, so will the call option. However, there is more to an options price than the stock price.

An option’s price is composed of three primary elements: price, time and volatility. Think of these as the three main ingredients in a recipe for the option premium.

 

 

Compare this to a recipe for bread – bread and other baked goods start with just three main ingredients: flour, water and yeast.

The ratios used in a bread recipe can vary to achieve different results, but the three main ingredients are the basic foundation.

So what do these three ingredients do?

Depending on how they are mixed, they help determine the price of a call option contract.

The three ingredients of an option price are often divided into two categories: intrinsic and extrinsic value.

 

Intrinsic & Extrinsic Values: Time vs Value

 

 

Let’s start with intrinsic value, which is based on the underlying stock price.

If you have a call option with a thirty dollar strike price, the difference between the stock price and the strike price determines the intrinsic value.

If the stock is currently trading at thirty-two dollars per share, the intrinsic value is two dollars. An option that has intrinsic value is said to be “in the money’.

However, if the stock is trading at twenty-eight dollars per share, there would be no intrinsic value in the option, and it would be considered “out of the money’.

After determining the intrinsic value, its easy to establish the extrinsic value, because its the remaining portion of the option premium.

You’ve learned that the option premium equals the sum of the intrinsic and extrinsic values, therefore, you can also say that extrinsic value is equal to the premium minus that intrinsic value.

If flour represents intrinsic value, then water and yeast represent extrinsic value. In options, these ingredients are time and volatility.

Taking a closer look, time value evaporates over time. Which means that if the price of the underlying stock isn’t moving, your options could be decreasing in value.

Because a call is a contract to buy a stock at a set price before a specified date, the closer the options get to that expiration date, the faster time value evaporates.

 

 

A call buyer wants the price of the underlying stock to move quickly to offset the loss of time value – and a call seller wants to take advantage of the evaporation over time, and hopes the price will stay below the option strike price.

Because time value evaporates faster the closer an option gets to expiration, many call sellers sell options that are only a month or two away from expiring.

If water and time are related, how are volatility and yeast related?

Active yeast helps bread rise and become larger. Rising volatility tends to increase the value of the option premium.

Implied volatility is the future expectation of the stock’s price movement, and derives its value from the supply and demand for options.

In other words, if investors are expecting increased price fluctuation, such as from an earnings announcement, the option price will inflate.

 

 

 

Swelling in implied volatility usually occurs because there’s higher demand for options, and like any product, the price rises because demand increased.

Likewise, when there are a large number of option sellers supply increases and the price will fall until there are enough buyers to fill the orders.

This is why call buyers may look for options that have relatively low implied volatility that appears to be rising – whereas, call sellers might sell call options when implied volatility is high and starting to fall.

 

 

Let’s review what you learned.

Option premium is made up of three parts: price, time, and volatility.

Next you discovered how these three ingredients are categorized into intrinsic and extrinsic value. Then, you found out how each ingredient can help or hinder a call trade.

Finally,  you learned that calls with intrinsic value are said to be “in the money”, and calls with extrinsic value are only considered to be “out of the money”.

 

 

Quick Recap

In Review….

Call Options Trading

 

  • A call option is a contract that gives the buyer the right to buy one hundred shares of stock at a set price, on or before a certain date
  • While most contracts represent one hundred shares of stock, there are some that represent as few as ten shares
  • A call option can be used as a substitute to buying stock. By purchasing the call option, you purchased the right to buy the stock at a set price, known as the strike price
  • However, you only have this right for a set period of time, because the call option has an expiration date
  • As the underlying stock price rises in value, so will the call option. However, there is more to an options price than the stock price
  • An option’s price is composed of three primary elements: price, time and volatility. Think of these as the three main ingredients in a recipe for the option premium
  • The three ingredients of an option price are often divided into two categories: intrinsic and extrinsic value

 

Intrinsic Value

 

  • Intrinsic value is based on the underlying stock price
  • The difference between the stock price and the strike price determines the intrinsic value
  • An option that has intrinsic value is said to be “in the money’

 

Extrinsic Value

 

  • After determining the intrinsic value, its easy to establish the extrinsic value, because its the remaining portion of the option premium
  • You’ve learned that the option premium equals the sum of the intrinsic and extrinsic values, therefore, you can also say that extrinsic value is equal to the premium minus that intrinsic value
  • Extrinsic value consists of time and volatility
  • Time value evaporates over time. Which means that if the price of the underlying stock isn’t moving, your options could be decreasing in value
  • Because a call is a contract to buy a stock at a set price before a specified date, the closer the options get to that expiration date, the faster time value evaporates
  • A call buyer wants the price of the underlying stock to move quickly to offset the loss of time value – and a call seller wants to take advantage of the evaporation over time, and hopes the price will stay below the option strike price
  • Because time value evaporates faster the closer an option gets to expiration, many call sellers sell options that are only a month or two away from expiring
  • Rising volatility tends to increase the value of the option premium
  • Implied volatility is the future expectation of the stock’s price movement, and derives its value from the supply and demand for options
  • In other words, if investors are expecting increased price fluctuation, such as from an earnings announcement, the option price will inflate
  • Swelling in implied volatility usually occurs because there’s higher demand for options, and like any product, the price rises because demand increased
  • Likewise, when there are a large number of option sellers supply increases and the price will fall until there are enough buyers to fill the orders
  • This is why call buyers may look for options that have relatively low implied volatility that appears to be rising – whereas, call sellers might sell call options when implied volatility is high and starting to fall

 

 

 

These are the basics that one should know if he or she chooses to trade call options. You could of course, buy and sell calls – or even conduct high order trades and strategies according to your risk level and experience.

Remember, for call buyers, you want the price of the stock option to increase above the strike at the time of expiration – and for call sellers, you want the price of the stock option to decrease below the strike at the time of expiration.

All option transactions requires the exchange of a “premium”; for buyers this is the price you pay (debit) to the seller who receives it in the form of a credit. If a call buyer wins the trade, they get to reclaim their debit from the seller. But if the seller wins the trade, they will be able to keep the credit from the buyer, who loses the trade.

The option premium consist of three things: price, time and volatility – whereas the price is classified as the “intrinsic value” while time and volatility are classified as “extrinsic value”. Time decay and volatility can either eat away at the intrinsic value of an option, or it could be used to the advantage of a trader to capitalize on the gains of future price movements.

The jist is to buy when implied volatility is low and on the rise, and sell when implied volatility is high and starting to fall – hence the stock market golden rule: “Buy Low, Sell High”.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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