Are you a novice in the field of trading? Are you still confused about stocks and other assets? Do you need help from trading calculators but are skeptical about how to use them? Well, relax and keep reading because we are here to relieve your confusion. Building a foundational base with basics should be the first step of learning. Hence, we bring to you the easiest of all trading calculators, option calculators. It may seem like a puzzle to you right now but read along and we will help you to get your basics clear.
- What are the Options?
‘Option’ is a word that most of us use in our everyday lives. It refers to variety or multiplicity. However, in trading, ‘option’ stands for an altogether different meaning. Hence, we first need to understand what ‘option’ stands for in the trading world. Options are trading assets also known as derivatives because their value is attached to an underlying asset. It is a legal contract that provides the buyer with the right to buy or sell an underlying asset at a specific price on or before a certain date. The owner is, however, not obliged to do the same. Underlying assets are stocks, bonds, ETFs, etc. These are the actual financial assets regarding which a contract is formed.
These are used for added income, protection, and leverage and to improve a trader’s portfolio. They can best be used as a hedge during times when the market is declining. Hedging is a speculative tool wherein the trader comes to an offsetting position to induce gains and losses. It can be understood as insurance for your investment. Time plays an important role in options trading. With each passing day, the price of an asset keeps on decreasing. More time means higher chances of the price of an asset going up. If the time expires, your asset is wasted. Hence, options are also called wasting assets.
- Black Scholes Model
The options calculator is based on Black Scholes Model, also known as Black-Scholes-Merton Model. It is a mathematical equation that holds immense value in modern financial theory. It was developed in 1973 by Fischer Black, Robert Merton, and Myron Scholes, the latter two got a Nobel prize for the same. This model takes into account the impact of time and other risks surrounding the underlying asset to calculate an estimated value of derivatives. It requires five known variables, namely, the strike price of an option, the current stock price, the time to expiration, the risk-free rate, and the volatility. It is known for its accuracy yet sometimes there might be some deviations from the derived value and the actual value of the options. This slight deviation can be attributed to certain assumptions that the model makes. The only drawback of the model is that it takes into account only European options and not American ones.
- Options Calculator
Options calculator is an algorithm provided by the Black-Scholes Model which can successfully analyze and predict options. To understand how this calculator works we first need to understand the six inputs we need to put into it. The six inputs are spot price, interest rate, dividend, number of days to expiry, volatility, and option price. It will then calculate the outputs namely, the Greeks, the ex-ante value of the options, and the implied volatility. The Greeks refer to delta, gamma, theta, vega, and rho variables of options.
- The Inputs
Following is the list of the inputs with their meaning:
- Spot Price – Spot price is exactly what the term suggests. It refers to the price of an option at which it can be bought or sold at a given time and place. It is used as an indicator as well as the base price for any future predictions. The spot price is determined by the governing economic forces in a market, demand, and supply, and the policies of a given company. It is a fluctuating variable. It involves two important concepts of ‘bid quantity’ and ‘ask quantity’. The bid quantity is the maximum price an individual is willing to pay for a security. The asking price on the other hand is the minimum price at which a seller will sell his/ her security.
- Interest Rate – It refers to the amount charged by a seller over and above the principal amount of the security. The interest rate of an option is also known as the name of risk rate. Interest rates can affect all the variables in an economy. Hence, any fluctuations in interest rates may result in losses or profits. A rise in interest rate will lead to a decrease in the price of the security.
- Dividend – A dividend is an extra amount of reward or cash or any other benefit that a company lends to its shareholders. An ex-dividend will affect the put options positively and call options negatively. Going ex-dividend means that no more dividends will be paid on a particular security hereafter.
- Number of Days to Expiry – It simply refers to the number of calendar days left with a trader with the possession of the rights of an option.
- Volatility – It refers to any price movements regarding the market price of an underlying asset. It is a measurement of the speed and amount of movement in the prices of an asset. A trader needs to pay attention to the volatility of an option to understand its behavioral patterns better. By understanding the trends in the movement of an option over some time, predictions about implied volatility are possible.
- Option Price – Option price is the actual price or the intrinsic value in monetary and temporal terms of an underlying asset. It is calculated as a difference between the spot price and the strike price of an asset.
Strike price refers to the price at which an option is put or called. An options calculator will help one calculate the strike price and other Greeks of an option better. Once you have all the above-mentioned input variables, you can do predictions about the behavior of security. It will help one predict the right time for an option to be disposed of for maximum profits or minimize losses. You can avail of online calculators or consult an expert for the same.