Let’s talk about Options! In the money options, at the money and out of the money options.
What Is A Stock Option?
A stock option is a security that allows its holder to purchase a stock at a set price for a certain period of time. There are two types of options:
- Call option: This is the option to buy the underlying stock at the strike price (the predetermined price) and by a certain time. The obligation lies with the seller of the call (writer). If call buyer decides to buy (exercise stock options), the writer must sell the shares at the strike price. In other words, if you bought a call option on Facebook with a strike price of $30 that expires in two months, then the call buyer has the right to exercise that option and receive the shares. The writer now has the obligation to deliver those shares at the strike price.
- Put option: This is the right to sell the underlying stock at a specific strike price for a specific amount of the time. The buyer has the right to sell at the strike price and the writer is obligated to buy at that price. If you buy a put option at the $20 strike price to protect your gains, you have the right, until the date of expiration, to sell your shares for $20. Put sellers must purchase the shares for $20.
The reason that options are so popular is their versatility. In addition, they can be as conservative or speculative as the investor wishes. In other words, options allow investors to do everything from betting on the movement of an index to protecting a position from a decline.
What is Option Pricing?
There are a number of factors that determine the value/moneyness of an option. These include:
- Intrinsic value
- Current stock price
- Time of value
- Interest rates
Because of this variety, there are several options pricing models that use the above parameters of the fair market value of the option. However, the Black-Scholes model is most commonly used.
Similarly, moneyness is the position of the current, or future, price of an underlying asset with respect to the strike price of the option. It can be classified in one of the following three ways:
- In the money: This means that the option will have value at the date of expiration
- Out the money: This means that the option will not make money at the date of expiration
- At the money: This means that the current price and the strike price have equal values
The longer the option term, the more value that these tend to have. This is because there is a greater chance that the stock will appreciate and the option will be “in the money.”
What is a Covered Call Strategy?
Also known as a “buy-write,” a covered call strategy is when investors sells their stocks, and future earnings that can be made from said stock, in exchange for cash today; this is usually done to increase investment income. These types of strategies are quite useful for generating profit in flat markets and can be used to provide higher returns, with lower risks, than their underlying investments.
There are three methods that can be used to utilize this type of strategy, they include:
- Index futures
- ETFs purchased on margin
Writing covered calls is an effective strategy but it takes time to learn. However, when you do, it will provide you with more investment opportunities.
Why are Options Part of Good Investment Strategy?
Calls and puts have the ability to add various levels of protection or leverage to a portfolio. Additional benefits include:
- Options can make a profit in bear, bull, or flat markets
- They can act as insurance to protect your gains in a shaky looking stock
- They can be used to effectively double or triple your money
The use of valuable tools, like a stock options calculator, make options even easier to use. A stock options calculator calculates the future value of your stock options based on the anticipated growth rate of the underlying company shares.
The Bottom Line
Options are a valuable asset because they offer investors flexibility. In other words, they enable you to easily adjust or adapt your position if a situation may arise. However, because this investment option can be complex, it is important that you do your due diligence before you decide if it is right for you.