There are two types of options. A call option is the right to buy or take a long position in a given asset (stock, commodity, index or futures contract) at a fixed price on or before a specified date. A put option is the right to sell or take a short position in a given asset.

The asset to be bought or sold under the terms of the option is the underlying asset or more simply the underlying. The exercise price, or strike price, is the price at which the underlying will be delivered should the holder of an option choose to exercise his right to buy or sell. The date after which the option may no longer be exercised is the expiration date.

As an example of an exchange traded option, the buyer of a FTSE100 Index October 5000 call option on the London International Financial Futures Exchange (LIFFE). Has the right to take a long position in one FTSE 100 Index Option contract (underlying), at the 5000 level (the exercise price) on or before October expiration (the expiration date).

When buying a put or call, your risk or loss, is limited to the premium you pay. When selling a put or a call, your risk or loss, is unlimited.

Buying a Call ......Bullish on the underlying asset. Profit potential only if market moves up.
Buying a Put .......Bearish on the underlying asset. Profit potential only if market moves down.
Selling a Call ......Bearish the market. Profit potential if market moves sideways or down.
Selling a Put .......Bullish the market. Profit potential if market moves sideways or up.

Traders frequently refer to options as being in -, at -, or out-of-the-money.

For an at-the-money option, put or call, the strike is approx the same as the futures price. For an in-the-money call, the strike is lower than the futures price. It has intrinsic value. For an in-the-money put, the strike is higher than the futures price. It also has intrinsic value. For an out-of-the-money call, the strike is higher than the futures price. Has no intrinsic value. For an out-of-the-money put, the strike is lower than the futures price. Has no intrinsic value.

Option premium is always composed of precisely its intrinsic value and its time value .

Insurance is an analogy commonly used to explain options, and some of the concepts are similar to say, buying car insurance. Insurance companies use mathematical models to determine price levels. Type of car, age of driver, historical record, and other factors, are all taken into consideration when determining the premium, and of course a profit is added in for the insuring company. Of course broker fees will also need to be taken in to consideration.

Many models have been developed by option traders to determine theoretical option prices. Good books are available for those who love to dwell on the mathematics of the issue. Keep in mind though, that models are only a gauge. However, they all include the factors that follow. But remember, emotions, news reports, and other public perceptions are non-calculable factors that determine the premium price levels.

Exercise (strike) Price - Naturally, an in-the-money option will be worth more than an out-of-the money option. An in-the-money option has a higher probability of expiring with intrinsic value than an out-of-the-money option.

Time. (days to expiration) - The longer to expiration, the more likely are the futures to go in the money. The longer the time, the higher the premium. The longer time your car is insured for, the higher the premium.

Option Volatility - Volatility is an important factor in determining the price of an option because all option-pricing models depend heavily on the calculation of volatility in determining the "fair market value" of an option. Volatility plays the most important role in actual trading decisions. Changes in our expectation about volatility can have a dramatic effect on an options value, and the way in which the marketplace assesses volatility will also have dramatic effect on an option. Volatility is the measure of price changes in an options premium. If a market were to stay in a tight trading range for a long period of time, the option would have low volatility, and therefore low premium. Conversely if a market were subject to violent price fluctuations the option would have high volatility and high premium.

Interest Rates - The least important factor for options that expire within a year is the interest rate. In fact, some of the financial futures prices are based on the cost of money, so the interest rate factor is already in the equation.

Decay of Time Value

All options contain time value up until the day they expire. However, this time is constantly eroding, causing the time value of the option to decline. This is why options are referred to as "a wasting asset". The diagram below shows how the time value of the option decays. The decay wastes away slowly until the option approaches the last few weeks to expiry. At that time, the time value decay really begins to accelerate, causing the option to quickly lose value, as market makers and buyers decide it is unlikely the underlying will gain value.

Again, it is important to note that the curve begins to accelerate approaching the last few weeks to expiration of the option. This is very important to know when you determine whether to buy or sell an option, or which expiration period to use. Also, the time value of, in-the money, at-the-money, or out-of-the-money options decay at different rates of time, with OTM options decaying at a greater rate near expiration.

As previously noted, the longer the option has until its expiration the more time value it has. Therefore, a December option to buy Gold at $800 will always have more time premium and value, than an October option to buy Gold at $800. This is because the additional time gives the option buyer more of a chance to be correct about his market view, and to receive a profit on his trade.

With a new president stepping up, promising to make significant changes in a country both at war, and with an economy on very shaky ground, all eyes point towards the Obama – Biden administration in hope, hope that the U.S can restore some stability and reassurance in the midst of this Global turbulence that we are currently experiencing right now.  
 

Big swings in Stock Indicies and Crude Oil are offering huge opportunities for professional Derivatives traders but we need to put into perspective the risks attached to longer term holdings on share portfolios. To better understand the risk associated with these markets, call your senior broker or ring us on 1300 760 377 to speak personally with one of our Investment Managers.