Part 2 Support and Resistance

1. How Option Pricing Works

Option pricing is determined primarily by two components:

1.1 Intrinsic Value

The intrinsic value of an option is the difference between the current market price of the underlying asset and the option’s strike price:

For a call option: Intrinsic Value = Max(0, Current Price – Strike Price)

For a put option: Intrinsic Value = Max(0, Strike Price – Current Price)

1.2 Time Value

The time value accounts for the possibility that the option’s price may increase before expiration. Factors influencing time value include:

Time to Expiry: Longer durations increase the likelihood of profitable movement.

Volatility: Higher volatility increases the potential for price swings, making options more expensive.

Interest Rates and Dividends: These factors can adjust the expected returns of the underlying asset and, consequently, the option premium.

1.3 The Black-Scholes Model

The Black-Scholes model is a widely used formula for estimating theoretical option prices. It considers factors like:

Current stock price

Strike price

Time to expiration

Volatility

Risk-free interest rate

This model forms the foundation of modern option pricing, though practical trading often considers market sentiment and liquidity as well.

2. Types of Option Styles

Options come in several styles, each dictating when the option can be exercised:

American Options: Can be exercised any time before expiration.

European Options: Can only be exercised on the expiration date.

Exotic Options: Include complex derivatives such as barrier options, Asian options, and lookback options, often used by institutional investors.

3. Uses of Options

Option trading serves multiple purposes in financial markets:

3.1 Hedging

Investors use options to protect their portfolios from adverse price movements:

Protective Put: Buying a put option to insure a long stock position.

Covered Call: Selling a call option on a stock already owned to earn additional premium income.

3.2 Speculation

Traders can use options to profit from anticipated price movements without owning the underlying asset:

Buying call options for bullish expectations.

Buying put options for bearish expectations.

Using leverage, a small investment can yield substantial returns if predictions are correct.

3.3 Income Generation

Selling options allows traders to collect premiums regularly:

Cash-Secured Puts: Selling put options while holding enough cash to buy the underlying asset if exercised.

Covered Calls: Generates income by selling calls against owned stock.

3.4 Arbitrage

Institutional traders use options to exploit price discrepancies between markets, combining options and underlying assets for risk-free profits.