How to Value Trading Options - dummies

By Joe Duarte

Part of knowing your risks and rewards results from understanding how an investment derives its value and what affects the rise and fall in its price. In order to value an option, you must know the following:

  • The type of option (put or call)

  • The market value of the underlying security

  • The characteristics of the past trading pattern of the underlying security calm or volatile

  • The time remaining until the option expires

Knowing your rights and obligations as an options trader

There are two types of options: calls and puts. By owning a call you have the right to buy a certain stock at a pre‐specified price by a certain date. Owning a put give you the right to sell a certain stock at a specific price by a certain date. Put option prices go up when the price of the underlying security falls.

Call option prices rise when the underlying security’s price rises. When you own options, you can assert your rights at your own discretion. So, between the time you buy an option and its expiration date, you can

  • Sell the option for a profit.

  • Sell it for a loss.

  • Exercise it.

  • Let it expire with no value (for a loss).

As an option seller, you are obligated to complete a specific set of requirements. In fact, selling options gives you fewer choices, and the actionable choices are heavily influenced by the action in the markets. As the expiration date nears, you can

  • Buy the option back for a profit.

  • Buy it back for a loss.

  • Let the option expire with no value (for a profit).

An easy memory trick to help you keep your rights and obligations in the correct framework is to think about buying the stock as calling it back while selling the option as putting the stock to someone.

Terms of endearment and importance

Here are key terms you have to nail down in order to make good option trading decisions:

  • Underlying security: The stock that you buy or sell and that determines the value of the option.

  • Strike price: The price you would pay if you decided to exercise your rights as an option buyer.

  • Expiration date: The date the option and your rights disappear.

  • Option package: The number of shares and the name of the underlying security that you can call away or put to someone.

  • Market quote: The most current price of a security that is being bid on by buyers and offered by sellers of options.

  • Multiplier: The number used to determine the value of the option and how much money you pay when you call away or put options to ­someone.

  • Premium: The total value of the option you buy or sell. The premium is based on the market quote for the option and its multiplier.

Option rights don’t last forever, so it’s important to keep track of how much time you’ve got left in a position before it expires. To figure out how much time you’ve got until the expiration date, identify the expiration date and determine the number of days or months away that date is.