Trading Options

A brief history

The first options were used in ancient Greece to speculate on the olive harvest. It was mid-winter, and the owner of the olive presses was happy to sell the right to use the olive presses during the harvest season. It generated income for the olive press owner during the off season.

The man purchasing the rights ensured that he would have use of the presses during the busy season. If the olive harvest was really good, the purchaser might be able to even resell his right to use the olive presses for a profit.

The stock options of today appear to have made their debut in what were described as “bucket shops”. It wasn’t until 1973 that the modern financial options market came into existence. The Chicago Board of Trade (CBOT) opened the Chicago Board Options Exchange (CBOE).

Option pricing

The option premium is a function of intrinsic value, time value and volatility.

Intrinsic value: The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option. The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option.

Time value: It is determined by the remaining lifespan of the option and the cost of refinancing the underlying asset (interest rates).

Volatility: Higher volatility implies higher premiums as the probability that the option will expire in-the-money increases with volatility.

Some heuristics used to come up with a price for an option:

  1. make sure put-call parity is respected
  2. a call of a certain strike K cannot trade at a lower price than a call K+ΔK (avoidance of negative call and put spreads)
  3. a call struck at K and a call struck at K+2ΔK cannot be more expensive than twice the price of a call struck at K+ΔK (negative butterflies)

There are theoretical option-pricing models, the most popular being Black-Scholes-Merton (BS), that can be used to price options. However, the primary use of BS in the real world is to trade the greeks.

This Khan Academy video does a good job of explaining the BS model:

Put-Call Parity

The put-call parity states that a portfolio of a long call option and a short put option is equivalent to (and hence has the same value as) a single forward contract at this strike price and expiry.

put call parity

The intuition behind this is: Call + Cash = Put + Underlying Asset

The put-call parity provides a simple test of option pricing models. Any pricing model that produces option prices which violate the put-call parity is considered flawed.

Options on StockViz

The BS Model greeks for “on the run” strikes (strikes closest to the underlying) are available for all listed options on StockViz. These values are updated on the fly using the latest market information.

NIFTY options screen

You can place (dummy) trades by clicking on the green button. This will allow you to track your options P&L over the life of the trade.

Option Traders Use (very) Sophisticated Heuristics, Never the Black–Scholes–Merton Formula
A Short History of Options
Put–call parity
Relationship between put and call

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