Explained Simply: Options 102, option pricing, Moo Moo's option price calculator, and the greeks

In this Options 102 for layman, we will discussed about option prices and its component of intrinsic and extrinsic value. We will also discuss about Black-Scholes theory of options pricing and how the greeks affect the option's price. In this post we will use Moo Moo's option price calculator a lot, so after we are done, we will be an expert on how to use Moo Moo's option price calculator. So let's begin

If you have not read Options 101 you can start from here

A option's pricing is made out of 2 components, and they are the intrinsic and extrinsic value. Extrinsic value is also known as time value. so in short intrinsic value + extrinsic value = option price. Let us understand the 2 terms first.

Intrinsic Value: In simple term, this is the option's "real value", because on expiration this is the only value left. This is the positive difference between the stock price and the strike price.

So for a CALL option, if the strike price of the option is $10 and the stock price is $15, the intrinsic value is $5 ($15 - $10). However, if the strike price of the option is $10 and the stock price is $5, the intrinsic value is $0, because no one will exercise this CALL option. Like why will the buyer exercise the option to buy shares at $10, when they can buy it at $5 right?

For a PUT option, it will be the inverse. If the strike price of the option is $10 and the stock price is $15, the intrinsic value is $0, because no one will exercise this PUT option. Like why will the buyer exercise the option to sell shares at $10, when they can sell it at $15 right? However, if the strike price of the option is $10 and the stock price is $5, the intrinsic value is $5 ($10 - $5).

Extrinsic value is determined by many factors which we will cover it later in the post. But let me layout a simple way of thinking of extrinsic value. More time, more hope, so cost us more money. Less time, less hope, so it will be cheaper. More volatile stock price, means higher chance to HUAT BIG BIG, so cost us more money. Less volatile stock price, means lower chance to HUAT BIG BIG, so it is cheaper.

Let us first focus on the intrinsic value and their related values which is underlined in red. We can see that the strike price is $150 from the option name. Tesla's current price is $164.31, and the intrinsic value is $14.31 ($164.31 - $150 = $14.31). Why is the intrinsic value $14.31? Because if we exercise the option now, we get to buy Telsa at $150 each, since Tesla is trading at $164.31, that means we can immediately sell the $150 shares for $164.31, earning us $14.31. Therefore, the intrinsic value is $14.31. This is the real value of the option.

Now let's take a look at the extrinsic value (time value) and 1 of the related value which is underlined in yellow. We can see that the time value is $24.39 and the expiry date of the option is 19 Jan 2024. Since the option have so much time left, the time value will be high. When we add the $14.31 in intrinsic value with the $24.39 in extrinsic value, we get $38.70. Which is exactly the option price.

By knowing the stock's current price, the option's strike price, the stock's price volatility, time left on the option and the risk-free interest rate, the model will output a theoretical price for the option contract. The math is as follows

But ain't nobody got time for Math! If we tried to work out the Math on paper or on Excel, the price would have changed because price is moving every seconds. So instead of doing all those Math on paper or on Excel, we can leverage off Moo Moo's option price calculator which does all these Black-Scholes math magic for us. It looks like this:

Under every option's Quotes page, there is this calculator at the bottom. This calculator knows the strike price, it automatically input the current stock price, calculates the current Implied Volatility (IV%) of the stock price and the time left on the option, and sets a default risk-free interest rate. With these values, it automatically calculates the theoretical price for the option. The fair price for the option. If we disagree with the IV or Risk-Free Rate, we can adjust it. If we like to do scenario analysis such as seeing how the option price will fall as time passes, we can adjust it and see the changes to the option price in real-time.

Now that we know that the price of the option is based on the stock's current price, the option's strike price, the stock's price volatility, time left on the option and the risk-free interest rate That would mean that the extrinsic value of an option is also a function of the stock's current price, the option's strike price, the stock's price volatility, time left on the option and the risk-free interest rate.

Let me explain it in layman terms, how those factors affects extrinsic value, which in our case is hope value.

Current stock price & option's strike price: If the strike price and stock price is too far apart, then we would pay lesser to buy hope. Because it is either too hard to win, or too hard to lose. Assume a CALL option, if the stock's price is $20 and the strike price is $100, it is extremely hard for the CALL option to win, so why will we pay more for hope? On the other hand, if the stock's price is $20 and the strike price is $1, it is extremely hard for the CALL option to lose, so why will we pay more for something that is almost guaranteed? Thus, the further apart the stock price and strike price is, the lesser we should pay for hope (extrinsic) value. Which means the closer the the stock price and strike price is the higher the hope (extrinsic) value.

Time left on the option: This should be quite obvious, if the option expires tomorrow, it is very unlikely that the stock price will move much as compared to an option that expires in a year. So the more time we have, the more hope we have, the more we will pay for hope (extrinsic) value.

Risk-free interest rate: For this, it is more like an opportunity cost. If you buy options, that means that you are losing money as you are not getting the interest. When you sell an option and get money, that means that you are putting the money to get the interest. Thus the model accounts for that so that it is fair for both the seller and the buyer.

the Greeks
Now that we know how options are priced, the next factor to look at is the Greeks. These are the key measurement of risk in the option. Knowing them will allow us to better manage risk. Advance traders could do hedging, like delta hedge, so that they are not affected by the movement of the stock's price. Whether the stock price goes up 1000% or crash to $0, it doesn't affect them. The Greeks are shown in every option chain as follows:

There are 5 greeks and they are delta, gamma, theta, vega and rho. Now let me explain them simply, with examples.

Delta: Measure the impact to the option's price when the share's price changes. It shows the change in the option's price for every $1 movement in the stock's price. So if we have an option that has a delta of 0.5, that will mean that if the share's price increase by $1, the option's price will increase by $0.50.

Delta is usually used as a proxy to measure the exposure we have with the underlying stock. Which means a delta of 0.5 would mean that holding this 1 option is as though we are hold 50 (0.5 x 100) shares. That is why buying a CALL option or short selling a PUT option have a similar effect to buying the shares. Conversely, a delta of -0.5 would mean that holding this 1 option is as though we short sell 50 (0.5 x 100) shares. That is why buying a PUT option or short selling a CALL option have a similar effect to short selling the shares.

Theta: Measure the impact of the movement of time on the option's price. It shows the change in the option's price for every day that has passed. So a theta of -0.5 means that if another day passed, the option's price will decrease by $0.50. Option's sellers loves theta, as it is the only thing that gives a guaranteed revenue. Time value will 100% go to 0 after expiry, so sellers are guaranteed 100% to earn from theta (but seller can lose due to other factors). Thus, there are a whole community of option sellers that have banded together and called themselves the theta gang

One thing to note is that theta burn will increase more and more as it gets closer to expiry. Theta burn will start to increase exponentially once there are only 30 days left on the option. Thus, a lot of option seller like to sell option that is close to expiration, to burn time value faster and earn from it.

Vega: Measure the impact on the option's price when implied volatility (IV%) changes. It shows the change in the option's price for every 1% movement in implied volatility (IV%). So a vega of 0.5 means that if the implied volatility (IV%) increase by 1%, the option's price will increase by $0.50. This is the key greek that we use to find trades that is ready for a IV crush

Rho: Measure the impact to the option's price when interest rate changes. It shows the change in the option's price for every 1% movement in interest rate. So a rho of 0.5 means that if interest rate increase by 1%, the option's price will increase by $0.50. But this greeks aren't really as significant as the others.

We know that Chinese's stocks had crashed for the past 2 years, and there is a chance that it could rally. But it could also not move at all. So before we make any options trade, we can make some assumptions for the different possible scenarios, and analyse the impact of it.

Using Moo Moo's price calculator, it will allow us to evaluate the risk and rewards based on our assumptions, and give us a clear idea if what we are going to do is a smart move or not.

Conclusion
Now that we have learnt more about options and Moo Moo's option price calculator tool, we can use them wisely in our trade so that we do not make silly mistakes. Like setting up an impossible to win option trade, or having a trade that gives us little reward but taking huge risks.

You could also join Moo Moo's option group chatroom too, to have more in depth discussion or simply to ask questions Just search options, click on groups and here are the 3 options group chat in Moo Moo