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51. Behavior of the Spread
52. Effects of Stock Price on the Time Spread
53. Effects of Volatility on the Time Spread
54. Vega values for calls and the corresponding puts
55. Time spread and its reaction to increasing volatility
56. Understanding and properly calculating accurate volatility levels
57. How to calculate the volatility of the spread?
58. Buyer Risk/Reward
59. Seller Risk/Reward
60. Rolling the Position, the Call Spread and the Put spreads
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Featured Article:
Option Parity
Parity - When we discuss parity in terms of options, we say that
parity is the amount by which an option is in the money. Parity
refers to the option trading in unison with the stock. This also
means that parity and intrinsic value are closely related. When we
say that an option is trading at parity, we mean that the option’s
premium consists of only its intrinsic value.
For example, if Microsoft was trading at $53.00 and the January 50
calls were trading at $3.00, then the January 50 calls are said to
be trading at parity. Under the same guidelines, the January 45 call
would be trading at parity if they were trading at $8.00. So, parity
for the January 50 calls is $3.00 while parity for the January 45
calls is $8.00
Now if these calls were trading for more than parity, the amount (in
dollars) over parity is called ‘premium over parity.’ Thus, the term
‘premium over parity’ is synonymous with extrinsic value, which was
discussed above.
If the stock is trading at $53.00 and the January 50 calls are
trading at $3.50 then we would say that the calls are trading at
$0.50 over parity. The $0.50 represents the premium over parity that
is also the amount of extrinsic value. The $3.00 is the amount of
intrinsic value or parity.
The term time decay is defined as the rate by which an options
extrinsic value decays over the life of the contract.
Volatility is defined as the degree to which the price of a stock or
other underlying instrument tends to move or fluctuate over a period
of time.
Implied Volatility is a value derived from the option’s price. It
indicated what the market’s perception of the volatility of the
stock or underlying will be during the future life of the contract.
A stock that has a wide trading range (moved around a lot) is said
to have a high volatility. A stock that has a narrow trading range
(does not move around much) is said to have a low volatility.
The importance of volatility is that it has the single biggest
effect of the amount of extrinsic value in an option’s price. When
volatility goes up (increases), the extrinsic value of both the
calls and the puts increase. This makes all the option prices more
expensive. When volatility goes down (decreases), the extrinsic
value of both the calls and the puts decrease. This makes all of the
option prices less expensive.
As stated earlier, a call option is a contract between two parties
(a buyer and a seller) whereby the buyer acquires the right, but not
the obligation, to purchase a specified stock or other underlying
instrument, at a predetermined price on or prior to a specified
date.
The seller of a call option assumes the obligation of delivering the
stock or other underlying instrument to the buyer should the buyer
wish to exercise his option.
The call is known as a long instrument, which means the buyer
profits from the stock going up, and the seller hopes the stock goes
down or remains the same. For the buyer to profit, the stock must
move above the strike price plus the amount of money spent to
purchase the option.
This point is known as the breakeven point and is calculated by
adding the strike price of the call to its premium. While the buyer
hopes the stock price exceeds this point, the seller hopes that the
stock stays below the breakeven point.
The buyer of the call has limited risk and unlimited potential gain.
His risk is limited only to the amount of money he spent in
purchasing the call. His unlimited potential gain comes from the
stock’s upside growth potential.
The seller, on the other hand, has limited potential gain and
unlimited potential loss. The seller can only gain what he was paid
for the call. His unlimited risk comes from the stock price’s
ability to rise during the life of the contract.
The seller is responsible for delivering the stock to the buyer at
the strike price regardless of the present market price of the
stock. This is why the seller receives premium for the sale. It is
compensation for taking on this risk.
For example, if a seller sold the MSFT January 65 call for $2.00, he
is giving the buyer the right to buy 100 shares (per contract) of
MSFT from him for $65.00 per share at any time until the option
expires.
If MSFT rallies and trades up to $75.00, the seller would realize a
$10.00 loss less the amount he received for the sale of the option
($2.00). Meanwhile, the buyer would realize a $10.00 profit less the
amount he paid for the option ($2.00).
If MSFT were to trade down to $55.00, the seller would realize a
$2.00 profit (the amount of money he was paid from the buyer).
Meanwhile, the buyer would only lose what he paid for the option
($2.00).
The following graphs are called parity graphs. They are intended to
show you your option’s profit and loss at expiration (when they are
trading at parity: i.e. when they are trading without intrinsic
value). The first graph shows a call purchase and the second shows a
call sale. The graphs show the amount of your expenditure (in the
case of a purchase) or the amount you have received (in the case of
a sale) and the dollar price of the stock where you would breakeven.
In this example, we use the fictitious stock XYZ. Please make note
of where the stock needs to be at expiration in order for you to be
profitable, and how the premium paid (in the case of a purchase) or
the premium received (in the case of a sale) affects your
profitability.
Also notice the difference in the profit potential between a
purchase of the option as opposed to a sale of the option. Lastly,
it is important to note the unlimited potential risk inherent in the
sale of an option, compared to the fixed risk of an option purchase.
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