Explaining Options Markets – Part 2

Pricing options for equities use the Black-Scholes method. The mathematical formula was developed in the late 1960s. Unless you were a math major, the formula is complex and won’t be repeated here. The formula uses the stock price, the exercise price, the interest rate, the standard deviation of the change in the stock price, and […]

Explaining Options Markets – Part 2

Pricing options for equities use the Black-Scholes method. The mathematical formula was developed in the late 1960s. Unless you were a math major, the formula is complex and won’t be repeated here. The formula uses the stock price, the exercise price, the interest rate, the standard deviation of the change in the stock price, and the time to maturity to determine the option price.

Implied volatility is an important concept in the pricing of options. Implied volatility is a function of an option’s price and is backed out from the price. Implied volatility shows the expectation of future volatility. Volatility is a one-standard-deviation annual figure. Volatility charts are invaluable for getting an idea of the relative value of an option.

Traders of stock options are engaged in a high stress high burnout position. Emotions frequently enter their decision making (a huge mistake in trying to make money in trading). The traders can hold positions in options for years, months, weeks, days, or minutes. Furthermore, the trader is trying to predict the directions of numerous stock markets across the globe and try and make money on that.

It is important to keep in mind that a call option gives you the right but not the obligation to buy the underlying security for the option. Similarly, a put option gives you the right but not the obligation to sell the security. Most options are never exercised. That is, the buyer or seller of the option doesn’t have an interest in owning the underlying. They usually only have an interest in making money on the option.

Options can be bought and sold online via a broker such as Optionsexpress which is owned by Charles Schwab. Options have bid and ask prices. The bid for an option is what someone is offering to pay for that option. The ask price is what someone is willing to sell an option for. An options buyer can place a limit order for an option which tells the seller of an option what is the maximum amount that they are willing to pay for an option. This order may or may not be filled depending on the direction of the underlying security and possibly the market overall. These orders are generally filled electronically but some human intervention may be involved.

Many buyers or sellers of options will place an order to sell the option at a particular price if the option reaches a particular profit or loss amount (either dollar amount or percentage). This will limit the losses of the speculator and take profits when they desire.

The vast majority of individual investors lose money buying or selling options. The options markets are complex for most retail investors to understand and are best left to professionals. That being said, there are no billionaires who claim that they have made their riches buying and selling options.

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