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Transcript
One key thing to understand how options really work is understanding how stock price movement affects options prices.
In this video, we’ll explain how this actually plays out using a fictional company with hypothetical examples but using real world data so you can get a rough idea of how these financial instruments work.
Understanding the basics of how stock prices affect option prices will give you a general understanding of why options are extremely powerful, but come with their trade offs.
Let’s get into it.
Imagine a fictional company called Toastr, Toaster is in the business of selling smart toasters. And get this, they recently developed a new technology that will prevent toast from ever burning. Or so they say.
Now, some people are excited about this, but not very many. Let’s suppose you’ve been a longtime Toastr fan and you really understand the toast market.
You think that the stock could really soar. And maybe you’ve heard that options can help increase one’s potential gain. So you want to know how purchasing a bullish call option would play out?
Suppose that right now the stock is trading at $60. Since this event is in roughly three weeks, let’s suppose you opt to purchase an option that expires in four weeks.
Usually you can purchase an option for many different strike prices, but let’s focus on three of them categorically.
One is ‘in-the-money’, which is to say below the current stock price.
One is ‘at-the-money’, which is to say about roughly at the current stock price.
And one is ‘out-of-the-money’, meaning that it’s above the current price of the stock.
So what would happen to each of these options’ premiums?
The first option has a strike price of $45. It’s in-the-money by $15 and costs $1,700.
The second option has a strike price of $60. The current price of the stock. It’s at-the-money and costs $270.
And the last option has a strike price of $75. It’s out-of-the-money by $15 and costs only $3.
Now what happens to the premium, the price of each of these options contracts, if the stock price of Toastr shoots up to $69 immediately ?
The in-the-money option would be worth $2,600, a 53% gain.
The at-the-money option would be worth $1,170, a 333% gain.
The out-of-the-money option would be worth $4, a 33% gain.
Notice that the option that is out-of-the-money is cheapest because the stock has to move more to make any money.
As a rule of thumb, the further out-of-the-money an option is, the less expensive it will typically be.
But hold on a second. The out-of-the-money option yielded a substantial gain and could be sold immediately for an impressive trade.
One take away might be, if your option is going in the right direction and it still has some time value, you don’t have to wait until expiration to sell it.
As you can see, the at-the-money option actually had the best result.
One way to approach options is to think of them as finding the sweet spot that yields the greatest ROI, if your prediction about the market is correct.
But the strike price isn’t the only thing that can change the value of an option, let’s take a look at options with the same strike price, but with expirations three months out instead.
The first option has a strike price of $45. It’s in-the-money by $15 and costs $1,800.
So why does it cost more than the four weeks option? Because it has more time. This is called the time value of the option.
The second option has a strike price of $60. The current price of the stock, it’s at-the-money and it costs $375.
And the last option has a strike price of $75. It’s out-of-the-money by $15 and costs $5.
As you can see, the options that have longer expiration periods tend to cost more because you’re paying for that additional time value. The stock has more time to reach your goal.
Now what happens to the premium of each of these contracts if the stock price of Toastr shoots up to $69 immediately?
The in-the-money option would be worth $2,700, a 50% gain.
The at-the-money option would be worth $1,275, a 240% gain.
And the out-of-the-money option would be worth $8, a 60% gain.
These options with a longer time period aren’t too different. In general, the more in-the- money an option is, the more it behaves like a stock.
The sweet spot was once again the at-the-money option. It saw the largest gain because it gained intrinsic value.
At a strike of $60 with a stock price of $69, that contract is now worth $9 at expiration.
The out-of-the-money gains 60% which is still sizable, but the stock still has a long way to go before that option gains intrinsic value.
Please note this is a simplified model. In reality a multitude of factors can affect the prices of options contracts.
Now while this is a simplistic blueprint, the key takeaway here is that generally speaking in-the-money options act more like the stock price.
At-the-money options offer enhanced risk reward, and the apparently cheap out-of-the-money options are unlikely to expire with any value. And even though they seem like a good bargain, they often are not.
Happy trading.