Dr. Scott Brown Stock Options

Principle 1: Lower Strike calls (and higher strike puts) must be more expensive For a Call Option, a lower strike price has a higher premium to pay since there is more upside to the call. The buyer of a call will have greater earning potential since the call has more intrinsic value. It’s the opposite for a higher strike price. Since the call has a smaller intrinsic value, the potential earnings will be lower and thus the price for the call is lower. For a Put Option, a higher strike price has a more expensive premium since it offers a larger potential gain to the option buyer. The intrinsic value of the put is larger. It’s the opposite for the lower strike price. The intrinsic value is less expensive making the potential gain on the put lower.

What is arbitrage? Arbitrage is a process by which “free” money can be made. An arbitrageur is a trader who searches for these opportunities. An arbitrage happens when, for instance, the higher strike price in a call option has a higher premium than the lower strike price. To exploit this situation, arbitrageurs BUY the lower strike and SELL the higher strike, receiving a net credit. The arbitrageur has a guaranteed profit. Arbitrage keeps prices in line so that you can rest assured that you are most likely getting the right price for the option all the time!

Principle 2: More time means more money Longer term call options are more expensive because the markets realize that there is an advantage on your side since the option has a greater chance of increasing in value because more time will pass. The same applies to put options. Since there is more time, the chances of a put option falling more are more likely.

Square Root Rule: Option prices are proportional to the square root of tine. If, for instance, time increases by a factor of four, then the price of the option doubles. This is exactly the square root of four. If you double the time of an option, then the option will rise by the square root of 2 or about 1.41 times. This is a very useful rule for you to memorize!

Principle 3: At expiration, all options must be worth either zero or their intrinsic value For an option that is in-the-money, at expiration the price must be the difference between the strike price and the exercise price. Because long options cannot have negative value, all at-the-money and out-of-the-money calls expire worthless. At expiration, put options must be worth zero or their intrinsic value, which is found by subtracting the exercise price minus the stock price. Arbitrage is possible when a put option is in-the-money at expiration and not selling at its intrinsic value. Arbitrage will force the option to sell at its intrinsic value.

Principle 4: Prior to expiration, all at-the-money and in-the-money call options must be worth the stock price minus the present value of the exercise price Prior to expiration, all in-the-money call options must be worth at least the stock minus the present value of the exercise price. This means that all in- the-money call options must be worth their intrinsic value plus an amount equal to the cost of carry of the strike price. Time value of money = a dollar today is worth more than a dollar tomorrow The difference between the exercise price and its present value is the today’s value of the interest that could be earned on the exercise price. The fourth principle simply states that there is an interest component to an in-the-money call option’s price as well as an intrinsic value component. Prior to expiration, a put option must be worth at least the exercise price minus the stock price. It must be worth its intrinsic value plus some additional value for the time remaining.

Principle 5: The maximum price for a call option is the price of the stock. The maximum price for a put option is the price of the strike. While stock prices may theoretically be unlimited, the same is not true for an option. Options are tied to the price of the stock and the strike price defines the maximum price of the call option.

Pricing Principal 6: For any two call or put options, on the same stock with the same expiration, the difference in their prices cannot exceed the differences in their strikes. The market corrects situations where the difference exceeds the strike price through arbitrage. The market will never give you more than the differences in strikes for any options whether calls or puts (assuming the same underlying stock and time to expiration).

What gives an option value? First, we know that the option’s price, or premium, can be broken down into the two component parts; intrinsic value and time value. There are at least two factors that give an option value. The first is a favorable stock price movement and the second is time. A call option locks in a buying price for the stock. The higher the stock price, the more valuable a call option becomes. If you are holding a put option, you’d like the underlying stock to fall. Since a put option locks in a selling price, the further the stock falls, the more valuable the put option becomes. The time value of an option is solely determined by the market’s perception of the volatility of the stock between now and expiration.

What is the Delta of an option? When trader’s talk about how an option’s price moves in relation to the underlying stock, they are talking about Delta. Delta is measure of how much an option’s price will move for the next immediate one-dollar move in the underlying stock. Delta simply shows us how sensitive an option’s price is to changes in the stock’s price at that moment in time. Put Deltas are always shown as a negative number. This is not because there is a negative probability of them expiring in-the-money. Rather it is a notation to remind us that a put loses value as the underlying stock rises and gains value as it falls. The KEY POINT is to remember that an option’s price will generally not move dollar-for-dollar with the underlying stock.

Disclaimer DISCLAIMER: THE DATA CONTAINED HEREIN IS BELIEVED TO BE RELIABLE BUT CANNOT BE GUARANTEED AS TO RELIABILITY, ACCURACY, OR COMPLETENESS; AND, AS SUCH ARE SUBJECT TO CHANGE WITHOUT NOTICE. WE WILL NOT BE RESPONSIBLE FOR ANYTHING, WHICH MAY RESULT FROM RELIANCE ON THIS DATA OR THE OPINIONS EXPRESSED HERE IN. DISCLOSURE OF RISK: THE RISK OF LOSS IN TRADING FUTURES, FOREX AND OPTIONS CAN BE SUBSTANTIAL; THEREFORE, ONLY GENUINE RISK FUNDS SHOULD BE USED. FUTURES, FOREX AND OPTIONS MAY NOT BE SUITABLE INVESTMENTS FOR ALL INDIVIDUALS, AND INDIVIDUALS SHOULD CAREFULLY CONSIDER THEIR FINANCIAL CONDITION IN DECIDING WHETHER TO TRADE. OPTION TRADERS SHOULD BE AWARE THAT THE EXERCISE OF A LONG OPTION WOULD RESULT IN A FUTURES OR FOREX POSITION.HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL, OR IS LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. PS. In our opinion, we believe, it may be possible, that heavy smoking and drinking may be hazardous to your health. If you choose to smoke and drink while trading, The Delano Max Wealth Institute, Caribbean Investment Club, nor Dr. Scott Brown is liable for any damage it may cause. If you slip and fall on the ice, we're not liable for that either.