Some traders have had success in options trading by means of disciplined techniques and processes. The market trends as well as the price movements are the factors they are keeping a watchful eye on for years. Others also rely on trade rallies and reversals if not identifying a fairly good number of potentially-earning stocks. On the other hand, not all people gain confidence by simply following these trends and criteria. Most of first-time traders are clueless as to how to invest and buy options and stocks. Besides, how many amateur traders realize that pricing of options effects eventual profits in the long run?
Entering into the fierce and competitive world of options trading also means having a clear comprehension of option pricing and valuation. Terms such as stock price, intrinsic value, volatility, dividends and time value are just a few of the important things to remember and understand.
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Pricing of options, in general, has a great effect on potential profits and income. For traders, they have to be wary not only of price changes but movements within trading periods and exchanges. They also have to learn the so called determinants of an option’s price to further control and correctly identify profits. So, what are these determinants?
Current Stock Prices have a direct effect on the price of options. An increase in stock prices will spell an increase in call options’ price and a decrease in the price of put options.
Intrinsic value, on the other hand, refers to an option’s minimum value. A financial gain is expected once a given option is exercised. However, out of the money (OTM) transactions have no intrinsic value of any kind.
Call Option Intrinsic Value = Underlying Stock’s Current Price – Call Strike Price
Time value also has a relative effect on pricing of options. The more time a trader has before his options expires, the greater are his chances to earn higher income. Simply put, time value is considered a direct factor affecting option’s price. Below is a given formula:
Time Value = Option Price – Intrinsic Value
Other factors such as interest rates and volatility also affect a trader’s income. As a general rule, a stock investor, who is keen in buying call or put options, must learn how to use and control his stocks. Arguably, this is easier said than done, given the many tips and tricks he has to learn in time. Still, it is imperative to learn how pricing of options is done in order to regulate trading transactions, determine price movements and anticipate profits or income.
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