The 1977 Nobel Prize was awarded to Fischer Black and Myron Scholes – the two men behind the option pricing model.
Now, you may be wondering – why am I talking about these two award winners from 42 years ago?
Well, the equation these guys created is the reason that we, as option traders, are able to reduce risk and make money in multiple directions.
It’s elegant, to say the least. I’d even go as far as to call it beautiful!
Understanding how options are valued is a crucial part of harnessing their power. In order to trade like the pros, you need to know the breakdown of option pricing.
That’s exactly what I’m going to show you today. And trust me – it’s a whole lot simpler than any math equation you learned in high school.
Here’s how to harness the power of option valuation…
Use Option Valuation to Churn Out Bigger and Safer Profits
Unlike a stock, options are derivatives. That means their value is derived from an underlying stock, amongst other things.
Now, the math behind the scenes is very sophisticated, as you can see below…
But you don’t have to worry about that. All of the calculations are done for you!
Some of the moving parts used to calculate an option’s value include: stock price, strike price, time until expiration, and risk-free interest rate. The grandfather of all options pricing models is called the Black-Scholes model.
That’s the model that won Fischer Black and Myron Scholes the Nobel Prize in Economics in 1977. And today, it provides us with a myriad of ways to make money. With this model, we’re able to make money up, down, and sideways. If you think you know where a stock is going to go, you can make money on it with options.
But you don’t need to know the Black-Scholes model or any of the other option pricing models out there to trade options.
Instead, I’m going to break it down for you in simple terms.
A few weeks ago, I told you all about the anatomy of an option. Now, we’re going to look at how it’s valued…
You’d probably never think of options and milk as having anything in common. But the first thing to understand about an option is that it has a shelf life. Like milk, options have an expiration date. And the amount of time left before this date hits has a value.
This is called time value, and it is baked into an option’s price.
Remember – time costs money. So, if you buy an option that expires in a year, it’ll cost you more than one that expires next month.
It’s like sand dropping through an hourglass. As time passes, the time value of an option decreases.
Let’s say, for example, a $5.00 option has $2.50 of time value. The remaining $2.50 is called real value (intrinsic value).
The instant you buy an option, the sand starts flowing, and you’re in a race against time. The stock must move quickly enough to offset the time decay in the option.
Unknown to most novice option traders, the sand in the hour glass of time value falls at a faster rate as the expiration date approaches. In other words, time value erodes faster and faster as the option approaches expiration, meaning you have to be right on direction faster. Time decay is biggest in the last 30 days.
Buying 60-day or longer options is a good way to avoid excessive time decay.
Consequently, I offer beginner traders the following rule:
Buy 60-90 day options and exit all options with 30 days to expiration.
Now, onto the second half of an option’s value. Real value is the portion of an option’s value that is intrinsic to the option. This is why it’s also called “Intrinsic Value.” It’s the amount that the option must be worth based on the rights it provides.
For example, if XYZ is trading at $50, an XYZ $45 call (which provides the right to buy XYZ at $45) must be worth at least $5.00.
That’s because if you were to exercise your right, you would buy the stock for $5 less than it’s worth. So, the option must be worth at least that.
An option that has real value is considered “In-The-Money (ITM).”
Real value is easily calculated, as shown below:
|ITM Calls (Strike < Stock)
|| ITM Puts (Strike < Stock)
|Stock Price – Strike Price
||Strike Price – Stock Price
So, in the example above, if the XYZ $45 Call is worth $7.00, with the stock trading at $50, then this option has $5.00 of real value.
$50 – $45 = $5.00
The remaining $2.00 is time value.
If the stock stays flat, then the risk in this trade is $2.00 that will be realized upon expiration.
Taking a look at the option table from last week, you’ll notice that ITM options (shaded gray) all have real value. ITM options will also have time value, provided there is still time before expiration.
Options that are “At-The-Money” (ATM) or “Out-of-The-Money” (OTM) all have time value only.
Time Value Trade-Off
Now, you may be thinking that you should always buy ITM options to reduce the amount of time decay risk. And sure, it’s a logical assumption.
The truth is that there’s a trade-off. Options that are ITM have less time value and, therefore, less time risk. Options that are ATM or OTM have nothing but time value and are completely at the mercy of time decay.
So, here’s the trade-off… OTM options with 100% time value also double your money faster than ATM or ITM options. So, if you want to make more money faster, you’ll want to deal with time decay full on. Be sure to have a strong directional opinion backed with a solid time target!
On the other side of the coin, if you want the option to behave more like a stock, you’ll want to use ITM options to squeeze out as much time value as possible.
Here are some rules to help you decide what type of options to use:
Less Time Decay Risk + Make Money Slower = ITM Options
More Time Decay Risk + Make Money FASTER = OTM Options
Now, you can’t forget about At-the-Money (ATM) options either. When you’re day trading, an ATM option could be your best bet.
In fact, I just developed a new trading tool that uses ATM options to potentially churn out impressive gains in just a few hours. With this tool, you could have the chance to make upwards of $4,000. Click here to learn more.
America’s #1 Pattern Trader