To The Moon

You know what options are and what their benefits are. When it comes to further understanding how options trading works there are a few things investors need to take into account. Knowing what factors impact the price of options and the right strategies to use is imperative. With the right options strategy, earnings season can be very profitable for experienced options traders.

As mentioned in the previous article, historically, earnings announcements have played a prominent role in moving stocks. As a result, they represent the understanding of a company's position in the unknown future in the world of investing. While projections and expectations are effective tools in modelling the direction and magnitude of equity plays, the world of options opens a plethora of new opportunities based on trading volatility. Knowing when and how to capitalise on mispriced options can yield some great returns. This is why having an understanding of the four most common strategies plays an important role in options trading.

Let's take a look at the factors that impact the price of options and a few options trading strategies.Firstly, how is the premium of the option determined? And do you predict the subsequent rise and fall after we buy the option?

1.Pricing of options

The so-called value determines the price, and there are two main factors that affect option pricing:

1.Intrinsic value

Intrinsic value is the calculation of what an asset is worth and is different from the market price. For instance, if there is a call option with a current strike price of $100, and a month later the holder of the call option can buy 1 share of Tesla stock for $100, assuming that the current Tesla stock price is $110, then regardless of other factors, how much should the call option be priced? The answer is $10, because whoever owns the option means that whoever buys a Tesla for $110 for $100 and makes a profit of $10, so the option is worth at least $10 based on the principle of no-arbitrage principle. The intrinsic value of an option refers to the amount that can be profited by exercising it immediately, that is, $10, the current price of the stock - strike price = intrinsic value.

2.Time value

Time value can be explained as, the amount the investor is willing to pay above its intrinsic value, in hope that the option's value increases before the contract's expiration date. For instance, if there is a current call option and the strike price is $100, the holder of the call option can buy 1 Tesla stock for $100 a month later, assuming that the current Tesla stock price is $90, then regardless of other factors, how much should the call option be priced? Many people think that the answer is $0, because the option will not be exercised at all, because no one will exercise $100 to buy a $90 stock, right? However, although no one seems to be willing to exercise now, the right granted by the option may be exercised after a month, and after a month the stock price is likely to rise above $100, exceeding the strike price, then the option will become valuable. And this uncertainty is the time value of the option.

Then the total value of an option is equal to intrinsic value + time value, but how do you calculate the two separately?

For example, if a call option is exercised at $100, and one month later, the holder of the call option can buy 1 Tesla stock at $100, assuming that the current Tesla stock price is $110, assuming that the option is priced at $12, then what is the intrinsic value and time value of the option at this time?

First, the intrinsic value is equal to the current price of the stock of $110 - the strike price of $100 = $10, and the time value is equal to $12 - $10 = $2.

What is the use of understanding the intrinsic value and time value for our investment decisions? Simply put, the total value of options includes intrinsic value and time value. If you buy expensively, the subsequent price will fall, and you will lose. If you buy cheaper, the subsequent price will rise, and you will make a profit.

In addition to pricing, there are many factors that affect the volatility of option prices. These are explained below.

2.Five factors that affect the price of options

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1.Delta value

Since the underlying asset behind the stock option is stock, the price of the options will also change when the stock price changes and the delta value measures how much the price of the option changes when the stock price changes by one dollar.Suppose a call option has a Delta of 0.2, which indicates that if the stock price rises by $1, all else being equal, the price of the contract will increase by $0.2.

2.Gamma value

Gamma represents the rate of change of Delta to the stock price, that is, the change in the Delta value for each unit of the stock price, and Gamma measures the sensitivity of the Delta value to the change of the stock price.Assuming that the price of a call option is $10, Delta is 0.3, and Gamma is 0.2, when the stock price rises by $1, all else being equal, the Delta of this call will become 0.5.

3.Theta value

Theta represents the change in the price of an option due to the passage of time, that is, the value of the change in the price of the option is Theta for each day of reduction. Assuming a Call or Put has a Theta value of 0.6, it indicates that the value of this options contract decreases by $0.6 per day all else being equal.

4.Vega value

Vega: represents the change in the price of an option by a unit change in volatility, because volatility is usually expressed as a percentage, Vega represents the impact of every 1% change in volatility on the price of an option. Assuming a call or put option has a Vega value of 0.35, the price of the option increases by $0.35 when implied volatility rises by 1%.

5.Rho value

Rho: Represents the impact of unit changes in the risk-free interest rate on the option price. Generally speaking, the degree of influence on the option price when the risk-free interest rate changes by 1%.However, these parameters will only be used when conducting option quantitative trading. For most investors, we just need to understand the commonly used money-making strategies and what their specifics are.

3. Four common strategies for options​

In the previous article's example, you can see that the most influential factor in the price of options is the underlying asset. For stock options, when the financial report data is disclosed, the stock price will change, resulting in option price changes, so the options profit strategy in the earnings season is mainly as follows.

1.Bullish strategy

When the financial report data exceeds expectations, the stock price is expected to rise moderately, and the put option can be sold. The maximum return is the put option premium. When the financial report data exceeds expectations, it is expected that the stock price will rise sharply, and you can buy call options, and the maximum return is the "stock price - strike price - premium" after the rise

2.Bearish strategy

When the earnings data is lower than expected, the stock price is expected to fall moderately, and you can sell the call option, and the maximum gain is the call option premium. When the financial report data is lower than expected, the stock price is expected to fall sharply, you can buy a put option, the maximum return is "strike price - the stock price after the fall - premium".

3.Oscillation strategy

When the financial report data is equal to expectations, the stock price is expected to rise moderately, and you can sell put options and buy stocks at the same time, so that the maximum gain has two main parts. One is the stock rise income, and the second is the premium for selling the put option. When the financial report data is equal to expectations, it is expected that the stock price will fall moderately. You can sell the call option while holding the stock, and if the stock falls, you can use the premium obtained by selling the call option to cover the loss caused by the decline.

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How effective are the above strategies in practice? For example, if there are three investors in ABC now, Tesla will disclose financial data a month later.

A thinks Tesla's stock price will rise in a month, but can't predict the increase

B thinks Tesla's stock price will rise by more than 5% in a month

C believes that Tesla's stock price will rise by 5%-10% in a month;

If they all buy stocks, if Tesla shares rise by 6% a month later, then the yield of all four investors is the same, all 6%, but this yield changes for people through option strategies.

If A chooses to hold Tesla stock directly, B buys a call option, and C uses a bullish call spread combination, assume that the yields of the three are as follows.

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It is clear that adopting a proper options strategy can magnify gains while controlling risk. How do you choose the right option strategy in different scenarios?

The above earnings season options strategy is just the beginning. If you want to know more comprehensive details about the options strategies mentioned in this article，You can see the digram below

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Data：tiger international investment education team

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In the following content, Tiger Academy will help you better understand them one by one!

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