Options Basics: How Options Work

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From time to option basics part 1 I write about the basics of options for the benefit of newer traders. About forty years ago an option pricing model, or formula, was devised, which option basics part 1 these influences into account in a very precise way.

Options had existed before then, but there had been no general agreement as to how they should be valued. Consequently there were no options exchanges and therefore no listed options. The publishing of the Black-Scholes model in coincided with an increase in available computing power. The model is a fairly complex set of partial differential equations.

But with the formula and the computers to calculate it quickly, an options market became possible. From the original twelve stocks with listed options inthe number of stocks with associated options has grown to over four thousand, or roughly half of all stocks and ETFs listed in the United States. The Black-Scholes model is not the only option pricing model. Others option basics part 1 followed it, with names like the Binomial Model and the Bjerksund-Stensland model.

The last five items listed above are the variables called the Greeks. Like any variables dreamed up by proper math nerds, they are named with Greek letters, hence the term. Delta is given in pennies per share of option price change, for the next one-point increase in the price of the underlying asset. For stocks, one point equals one dollar. So an option that has a Delta of.

Option basics part 1 that above I said that Delta is the number of pennies per share of option price change, for the next one-point increase in the price of the underlying asset. I used those words intentionally. There are two different types of options: Call option basics part 1, which are the right to buy the underlying stock; and Put options, which are the right to sell the stock.

Both types of options have Delta values, and they are of opposite signs. Since a put option is the right to sell the stock at a fixed price the strike pricethe put becomes more valuable as the stock price goes down.

That is because it then gives the right to sell the stock at a price which is above market. The farther above market something can be sold, the more valuable the right to sell it. So put options go up in value when their underlying stock goes down, and conversely down in value when the stock goes up. A put with a delta of. The Delta of calls option basics part 1 a positive number, and the Delta of puts is a negative number. But more option basics part 1, the Delta of an option can only be within a specific range.

For calls, the Delta cannot be a negative number, which is another way of saying that the Deltas of a call cannot be less than zero. Likewise the Delta of puts must be a negative number, so their value cannot be more than zero.

How can this be? Since a one-dollar change will make no difference in the price of this option, moving it from zero all the way to zero, its delta would be zero. The short answer is that an option can never move more, in pennies per share, than the underlying stock does, no matter how big the underlying stock move is. If this were not true, then there would be an opportunity for a risk-free profit.

And that option basics part 1 cannot persist for any longer than the milliseconds it takes for computers to detect it and trade it out of existence. Options that are deeply in the money have deltas of plus or minus 1. It too would change in value penny for penny with IBM stock, but in the opposite direction to the stock. Deltas are given in values per share, and option contracts are for share lots. So a Delta of. We had Puts available with Delta values of.

For the put with the. If we used the puts with the. And if we used the puts with the This usage of the Delta is as a hedge ratio. Finally, the Delta is said to give the approximate probability of the option finishing in the money. Notice that I wrote that the Delta is said to give that. We should not rely on this common interpretation of the Delta. For comments or questions on this article, contact me at rallen tradingacademy. Options July 8, Options Basics: Disclaimer This newsletter is written for educational purposes only.

By no means do any option basics part 1 its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever.

Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Option basics part 1 Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

Reprints allowed for private reading only, for all else, please obtain permission.

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