Options Pricing and Valuation

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Questions and Answers

What is the definition of a call option?

A call option is the right to buy a security at a predetermined price.

What is the definition of a put option?

A put option is the right to sell a security at a predetermined price.

What is the formula to calculate the intrinsic value (IV) of an option?

IV = Current Price - Exercise Price

What is the formula to calculate the time value (TV) of an option?

TV = Premium - IV Signup and view all the answers

What is an in-the-money call option?

An in-the-money call option has an exercise price lower than the current market price of the underlying security. Signup and view all the answers

What is an out-of-the-money put option?

An out-of-the-money put option has an exercise price higher than the current market price of the underlying security. Signup and view all the answers

What is the term used to describe paying a premium to have the right to sell a stock at a certain price and recover some losses?

stock price insurance Signup and view all the answers

What is the intrinsic value of a call option?

underlying security price - exercise price Signup and view all the answers

What does it mean when a call option is 'in the money'?

The exercise price is under the underlying price. Signup and view all the answers

What is the intrinsic value of a put option?

exercise price - underlying security price Signup and view all the answers

What does it mean when a put option is 'in the money'?

The exercise price is above the underlying price. Signup and view all the answers

What is the term used to describe an option where the exercise price is equal to the underlying price?

at the money Signup and view all the answers

What is the primary reason why a call option has greater profit potential than a put option?

A stock can go up an exponential amount, but it can only go down to zero. Signup and view all the answers

What right does the buyer of a call option purchase?

The right to buy a specific asset at a fixed price for a fixed length of time. Signup and view all the answers

What is the obligation of the seller of a call option?

The obligation to sell a specific asset at a fixed price for a fixed length of time. Signup and view all the answers

What is the break-even price for a buyer of a call option?

The strike price + premium paid. Signup and view all the answers

What is the purpose of buying a put option?

Because you think the stock price is going to go down. Signup and view all the answers

What is the break-even price for a buyer of a put option?

The exercise price – premium paid. Signup and view all the answers

How does a lower strike price affect the cost of call and put options?

A lower strike price makes call options more expensive and put options cheaper. Signup and view all the answers

What is the relationship between the time value of an option and its maturity?

As maturity increases, the time value of both call and put options increases. Signup and view all the answers

What does the delta of an option measure?

The delta of an option measures how much the price of the option will change for every $1 change in the price of the underlying security. Signup and view all the answers

How does the price of a call option change if the underlying security increases in value?

The price of the call option will increase by the delta value for every $1 increase in the price of the underlying security. Signup and view all the answers

Why is the time value of an option higher when the maturity is longer?

The time value of an option is higher when the maturity is longer because there is more time for the option to move into the money. Signup and view all the answers

How does lengthening the time to expiration on an option affect its price?

It causes the price to go up, as there is more time for the stock to move into or further into the money. Signup and view all the answers

What is the impact of an increase in volatility on the price of an option?

It increases the price of the option, as there is a greater chance of a price movement that will cause the option to be in the money. Signup and view all the answers

How do dividend payments affect the price of a stock and the prices of call and put options?

Dividend payments cause the stock price to go down, which in turn causes the price of call options to go down and the price of put options to go up. Signup and view all the answers

What is the effect of increased interest rates on the prices of call and put options?

Increased interest rates result in higher prices for call options and lower prices for put options. Signup and view all the answers

Why do options losses have a cap?

Options losses are capped because they are either in the money or not, regardless of the extent to which they are in the money. Signup and view all the answers

Why is increased volatility seen as good for options?

Increased volatility is seen as good for options because it increases the possibility of a price movement that will cause the option to be in the money. Signup and view all the answers

Study Notes

Option Concepts

A call option is the right to buy a security at a predetermined price.
A put option is the right to sell a security at a predetermined price.
Buy a call option if you think the stock price will go up, and buy a put option if you think the stock price will go down.
Call options have greater profit potential because a stock can go up exponentially, but can only go down to zero.

Intrinsic and Time Value

Intrinsic value of a call option: underlying security price - exercise price.
Intrinsic value of a put option: exercise price - underlying security price.
Time value of an option: premium - intrinsic value.
Time value represents the additional amount an investor is willing to pay for the option.

Option Basics

Buyer of a call option pays for the right to buy a specific asset at a fixed price for a fixed length of time.
Buyer of a put option pays for the right to sell a specific asset at a fixed price for a fixed length of time.
Seller of a call option pays for the obligation to sell a specific asset at a fixed price for a fixed length of time.
Seller of a put option pays for the obligation to buy a specific asset at a fixed price for a fixed length of time.

Breaking Even and Stock Price Insurance

To break even on a call option, the stock price must be equal to the strike price + premium paid.
To break even on a put option, the stock price must be equal to the exercise price - premium paid.
Options can be seen as stock price insurance, as they provide protection against potential losses.

Option Moneyness

An option is "in the money" when the exercise price is beneficial to the buyer.
An option is "out of the money" when the exercise price is not beneficial to the buyer.
An option is "at the money" when the exercise price is equal to the underlying security price.

Factors Affecting Option Prices

Underlying stock price
Strike price
Time remaining to expiration
Risk-free rate
Volatility of the underlying stock
Dividends
Lengthening the time to expiration increases the option price.
Increased volatility increases the option price.
Dividend payments decrease call option prices and increase put option prices.
Increased interest rates increase call option prices and decrease put option prices.

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Description

Calculate the intrinsic value and time value for different call options with varying exercise prices and expiration dates. Learn how to determine the premium and value of each option.