Explain Option Trading: Farmer Fred invents the option
To sum up: An option is an unequal (asymmetric) type of agreement where one party has the choice to go through with the sale/purchase or back out and the other party has to oblige. For the right to choose, the person who buys the option pays a premium to the writer.
Now you know the basics of what options are, how they work, the most important terminology used in option trading and how to make pay-off diagrams.
We need to think a bit more about what effects the value of an option. Gus was on the right track when he tried to figure out how much the price of the underlying moves. After all, the further the price of the underlying moves above the strike price, the more valuable a call option will be. Vice versa, a put option is more valuable the more the price of the underlying moves down. So intuitively options on underlying prices that move a lot are more valuable than options on underlying prices that don’t move much. Think about the extreme case of a fixed price. An option on something with a fixed price and a strike that is the same as the price of the underlying would be completely worthless.
The term for how much a price tends to move around is VOLATILITY. A price that is very volatile moves more than a price with a low volatility. Traders talk a lot about volatility. To them it’s the alpha and omega of option valuation. Volatility is measured as the standard deviation of the percentage change in the price. A more exact algebraic definition does not help much in the intuitive understanding of option valuation.
There is one more very important factor that effects option value. Over to Farmer Fred. Fred has thought a bit more about the fuel price and the call option he bought from Gas station Gus. Knowing that he can buy fuel at 10$ per gallon at harvest time made him sleep well at night. It’s like having an insurance against bad price changes just like Fred has insured his farm against fire. Fred is an expert on farming but fuel prices are not his area of expertise so paying the 0.7$ to Gus is a smart move. But, Fred thinks, there is a harvest next year too. And who knows what the price of fuel will be then? It’s only 3 months (time to delivery) to this year’s harvest but 15 months to next year’s. Fred figures nothing much will happen in 3 months but in 15? No one knows. Maybe an oil sheik raises his price or maybe a war starts that gets everyone worried. The more Fred thinks about all the things that could happen during those 15 months the more worried he gets. Better call Gus again to get an option for next years fuel too.
By now you’ve figured out that time to maturity is another major factor for the value of an option. In fact it’s THE other factor. Volatility and time to maturity are the two by far most important factors effecting the value of an option. They work closely together. Time is what gives volatility opportunity to work. The longer the time to maturity is, the longer time volatility has to move the price. With a long time to work, volatility has a much better opportunity to move the price a lot.