Stock Option Valuation (options pricing) is a complex topic and probably one of the toughest concepts you will encounter as you learn about options trading.
Because stock options are very different from shares of stock.
They have very specific and unique characteristics.
It is these characteristics that are going to determine if we are able to make a profit from the purchase of the option.
If you just blindly start trading stock options without having at least a basic understanding of stock option valuation and why options behave the way they do, then you're going to be in trouble and possibly lose a great deal of money.
It's like being a person who doesn't understand that it's a bad idea to go swimming in shark infested waters when you have a bleeding leg.
There are several components to stock option valuation (options pricing) that you should be aware of. It's not enough to merely know that you're going to buy an option contract and sell it later down the road.
The reason that stock option valuation is such an important concept is because option price does not always move in conjunction with the price of the underlying stock. There are other factors involved.
The following are six factors that determine what the price/cost of the option will be:
[+] The current market price of the stock
[+] The strike price of the option (particularly in relation to the current market price of the stock)
There are three different terms for describing the stock price to strike price relationship:
[+] Extrinsic Value: remaining life of the option (time left until expiration)
[+] Interest rates
[+] Stock Dividends
Interest rates and stock dividends are beyond the scope of this lesson. We will only be focusing on the first four.
**Side Note** If you hear someone talk about an options premium, or ask price they are talking about the cost to buy that option. So premium, and ask price are terms that mean how much you will pay to buy an option.
We will begin by discussing how the current market price of the stock affects an options value.
"The current market price of the stock:" When the stock price "increases" a Call options premium will "increase", but a Put options premium will "decrease".
When the stock price "decreases" a Call options premium will "decrease", and the Put options premium will "increase".
One easy way to remember it is that with "Call options" their price follows the direct movement of the stock price. If the stock moves up so will the Call options premium. If the stock price moves down the Call option will begin to lose value.
Put options are the exact opposite.
This will only make sense if you understand exactly how puts and calls work. For an overview of Puts and Calls return to the Puts and Calls lesson.
Buy Calls when you think the stock is going up and buy Puts when you think the stock is going down.
An options cost or market value is often called the premium.
All six of the above factors play an important role in determining an option's price. However, the only two factors that an investor has any control over are time to expiration and the strike price. These are the two factors that we will discuss in the next few lessons.
I don't know what has brought you to my page. Maybe you are interested in options to help you reduce the risk of your other stock market holdings.
Maybe you are looking for a way to generate a little additional income for retirement. Or maybe you've just heard about options, you're not sure what they are, and you want a simple step-by-step guide to understanding them and getting started with them.
I have no idea if options are even right for you, but I do promise to show you what has worked for me and the exact steps I've taken to use them to earn additional income, protect my investments, and to experience freedom in my life.
If you want to learn more, I invite you to download a FREE video case study on how to trade options like Warren Buffett.
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Module 1: Option Basics
Module 2: Option Value
Module 3: Basic Strategies
Module 4: Stock Charts
Module 5: Technical Indicators
Module 6: The 7-step process I use to trade stock options