InvestGen Archives | Page 64 of 65

Nov

2021

What Is a Bond Option? Definition & Examples

By Brian O'Connell | Growing Wealth, invest, Investing, Terminology | Comments Off

A bond option allows the contract holder to buy or sell an underlying investment (in this case, a bond) at a specific price and at a specific time. While considered less risky than stock options, bond options still typically carry higher risk than more traditional investments.

Like all options, bond options are derivative securities, used by investors to bet on the direction of an underlying security. Understanding what bond options are and how they work can help you understand these risks and determine whether bond options make sense for your portfolio.

Here’s a closer look at bond options, and the risks and rewards they bring to investors.

What are Bond Options?

A bond option is a legal contract to buy and sell underlying bond assets, usually via a call bond (i.e., the option to buy an underlying bond) or a put bond (the option to sell a bond) at a specific price (known as the “strike price)” at or before a specific time deadline (known as the “expiration date”).

For example, an investor might purchase a bond call option with a strike price of $900. The level value (also known as “par value”) of the underlying U.S. government bond is $1,000. Let’s say market conditions push the value of that bond up to $1,100. In that scenario, the option holder has the right to buy the government bond at $900 – even as the value of that underlying bond now stands at $1,100.

Investors typically trade options, including bond options, through over-the-counter exchanges. Bond options are also typically available wherever U.S. Treasury bonds are sold in fund form through investment companies.

Recommended: A Beginner’s Guide to Options Trading

Pros and Cons of Bond Options

There are benefits and drawbacks to incorporating bond options in your portfolio.

Pros of Bond Options

Higher return potential. As discussed in the example above, when executed well a bond options strategy can increase a trader’s gains on a particular investment. Bond options can also protect against downside risk. Investors often use bond options as hedges against more risk-laden investment strategies.

Risk hedging. Bond options investors can leverage derivative contracts to take advantage of interest rates and other short-term drives of investment performance. Investors can also lean on bond options to take advantage of pricing variations in options pricing or to position their portfolios ahead of major geopolitical events, like presidential elections, potentially big Federal Reserve policy decisions, or major recessions and other powerful economic forces.

Cons of Bond Options

The risk of non-exercise. Bond options investors may do well to let an options contract expire rather than execute a trade that goes awry and loses money. While a bond options investor isn’t obligated to exercise their bond options contracts, letting a contract expire means the original money used to buy or sell a bond option is gone forever. So, too, are the fees investment companies charge to handle options trades.

The risk of unlimited investment loss. While call options provide an investor with the possibility of unlimited gain if the underlying security rises in value, that same investor faces unlimited loss potential if that investor is selling a call or put option. If the underlying assets plummet to a value of zero, the options investor could face massive financial losses.

The risk of losing money quickly. As options, by nature, are short-term investing instruments, investors need to have extensive knowledge of near-term investment price movements to minimize the downside risk of investing in bond options. Often, traders make decisions about their options strategy based on a short time horizon. That means all options investors must master two key trading objectives – knowing the right time to purchase an options contract and knowing when to sell that contract, or cut losses by allowing the contract to expire without exercising the option to buy or sell by the expiration date.

Recommended: 10 Options Trading Strategies

Types of Bond Options

Bond options offer investors the right to buy or sell (via calls and puts) an underlying investment security at a specific time and at a set price.

Call Option Bonds

With a bond call option, if the price of the underlying bond option rises in value, the contract holder can earn a profit on the call by exercising the option to purchase the asset (with a call option) at a lower price and then selling it when the underlying asset goes up. A call option is in the money if the strike price is lower than the current market price of the underlying bond.

Bond Put Options

A bond options investor who buys believes a bond will go up in price may purchase a put option or put bond. With that option, buy the asset at the current low price and sell it at the rising strike price, assuming the price moves in the direction the trader had hoped. What a bond investor strives to avoid is being on the wrong side of an options trade, i.e., selling at a below market rate or buying at an above-market rate.

If an investor anticipates that bond prices will decline, given future expected market conditions, they’d purchase a put option. If the level value of the underlying bond option were$1,000, a bond put option gives the contract holder the right to sell the option contract at the strike price of $900 – on or before the expiration date. If bond prices fall, the underlying bond is now valued at $870. Now, that bond option investor can exercise the sale of the options contract at the strike price of $900, even as the bond’s value has fallen to $870. That guarantees a big profit for the investor, given the outsized nature of options contracts.

Embedded Bond Options

Embedded bond options are bonds in which the holder or the issuer has a right to take a specific action with a certain period going forward. Examples of embedded bond options include call provision, convertible provisions, and floored floating-rate provisions.

Callable Bond Options

Callable bonds are one type of embedded bond option. With callable bonds, the issuer has the option to repay investors the face value of the bond before the maturity date.

Bond Options Pricing

Given all the variables, including the current price and future price of a bond, volatility levels, interest rates, and time to expiration, it can be very complicated to properly price a bond option. Investors rely on several different mathematical formulas for this, including the Black-Derman-Toy Model and the Black Model.

The Takeaway

Options traders may use a bond option as a hedge against economic volatility in key areas like interest rates, currency rates, and bond yield rates, a bond option can be a useful portfolio management tool. However, there are plenty of other types of investments that an investor can use when building a portfolio, without trading bond options.

But for investors who are curious to start options trading, SoFi offers a user-friendly platform to do so. With an intuitive and approachable design, you can trade options on the web platform or through the mobile app.

Trade options with low fees through SoFi.

Photo credit: iStock/PeopleImages

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Oct

2021

What Is a Credit Spread? Explained and Defined

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

The term “credit spread” refers to two separate financial terms.

A credit spread is an important indicator of investor sentiment that compares the yields offered by Treasuries and corporate bonds as a way of understanding how optimistic or risk-averse investors are feeling.

But credit spread also refers to an options-trading strategy where an investor sells a high-premium option and simultaneously purchases a low-premium option on the same underlying security.

Credit Spread – the Market Indicator

A credit spread is the gap between the interest rate offered to investors by a U.S. Treasury bond versus another debt security with the same maturity. The differences in the yield of the different bonds, or credit spread, typically reflects differences in credit quality between Treasuries and other bonds.

Investors will also sometimes call credit spreads “bond spreads” or “default spreads.” For investors, credit spreads give investors a quick shorthand for comparing a particular corporate bond versus its risk-free alternative.

When investors refer to credit spreads, they usually describe them in terms of basis points, each of which is a percent of a percent. For example, a 1% difference in yield between a Treasury bond and a debt security of the same duration would be called a credit spread of 100 basis points.

For example, if a 10-year Treasury note offers investors a yield of 3%, while a 10-year corporate bond offers to pay investors a 7% interest rate. There would be a 400 basis-point spread.

Recommended: What is Yield?

The bonds issued by the U.S. Treasury are the benchmark of choice because the financial-services industry considers them relatively risk-free, given their backing by the U.S. government. Investors consider corporate bonds, on the other hand, riskier, even when they’re issued by the largest, longest-tenured and most highly rated companies in the most stable industries.

To purchase debt securities with that added risk, investors look for compensation in the form of extra yield. That’s why investors sometimes look at a debt security’s credit spread as an indicator of the perceived riskiness of a company’s bonds or the creditworthiness of the company itself.

Because they have a lower risk of defaulting, higher quality bonds can offer lower interest rates – and lower credit spreads – to investors. Conversely, lower quality bonds have a greater risk default, and so they must offer higher rates – and higher credit spreads – to compensate investors for taking on that risk.

Recommended: Pros and Cons of High-Yield Bonds

Why Do Credit Spreads Fluctuate?

The credit spreads of the bonds issued by a given company may change over time for a number of reasons. They may change because of macroeconomic fluctuations such as inflation, or the degree of market enthusiasm for the company issuing the bond.

When the equity markets seem headed for a downturn, both institutional and retail investors often sell stocks and corporate bonds, and then reinvest in U.S. Treasuries. That pushes down the yields offered by U.S. Treasury bonds as investors flee to safety, while the yields paid by corporate bonds rise in order to entice skittish investors. The result is a general widening of credit spreads across the board.

That dynamic is one reason that investors look at average credit spreads as a window into the overall market sentiment, in which wider credit spreads indicate declining investor sentiment. Narrower credit spreads typically signify more bullish sentiment among investors. That’s because during a bull market the safety of Treasuries holds less appeal to investors, forcing the notes to offer higher rates. Meanwhile, that same confidence leads investors to see corporate debt as less risky, allowing companies to issue bonds with lower yields.

What Is a Credit Spread in Option Trading?

Sometimes, investors use the term “credit spread” to refer not just to the difference in yield offered by a Treasury bond and a similar security, but also as a specific options trading strategy. The strategy is also sometimes known as a “credit spread option” or a “credit risk option.”

In an option credit spread strategy, an investor buys and sells options on the same underlying security with the same expiration, but at different strike prices. The premiums the investor receives on the option they sell should be higher than the premiums they pay on the option they buy, which leads to a net return for the investor.

The strategy takes two forms:

Bull Put Spread

In the bull put spread, in which the investor buys and sells options in which they’ll make a maximum return if the value of the underlying security goes up.

A bull put spread is often also called a put credit spread. In it, an investor sells a put option and purchases a second put option with a lower strike price. For the strategy to work, the investor buys the same amount of both options and, both options will have the same expiration date.

In a bull put spread strategy, as long as the price of the underlying security remains above a certain level, the strategy will begin to produce profits as the differences between the value of the two options begins to evaporate as a result of time decay. Time decay is how much the value of an options contract declines as that contract grows closer to its expiration date.

As the name indicates, the bull put spread is a strategy used by investors who are bullish on a security. And the higher the underlying security rises during the options contract, the better the investor will do. But if the underlying security falls below the long-put strike price, then the investor can lose money on the strategy.

Bear Call Spread

The other credit-spread is called the bear call spread, or a call-credit spread. That strategy is, in many ways, the mirror opposite of the bull put spread. Investors in this strategy expect that a security’s price will go down. In it, the investor buys and sells two options on the same security, with the same expiration date but at prices where the investor will receive the maximum return if the price of the underlying security sinks.

A bull put spread can be a profitable strategy if the investor remains under a certain level over the duration of the options contracts. If the security is below the short call’s strike price at expiration, then the spread seller gets to keep the entire premium, giving the investor a healthy return. But the risk is that if the price of the security rises above the long-call strike price at the expiration of the strategy, then the investor faces a loss.

Recommended: A Guide to Options Trading

The Takeaway

A credit spread is an important indicator of investor sentiment. It’s also an options strategy where a high premium option is written and a low premium option is bought on the same security. Understanding the meaning of terms like credit spread is an important step for new investors who are just starting to invest in stocks.

The SoFi options trading platform is a great way to get started, thanks to its user-friendly design. Investors can trade from the mobile app or web platform. And should any questions come up along the way, there’s a library of educational resources about options available.

Trade options with low fees through SoFi.

Photo credit: iStock/Astarot

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Sep

2021

What Are Vanilla Options? Definition & Examples

By Susan Guillory | Growing Wealth, invest, Investing, Terminology | Comments Off

Once you’ve started investing, you may want to learn about different assets beyond stocks and bonds. Among the alternative assets you might consider, are options, and vanilla options are a great way to get started with this type of investment.

Options give investors the — you guessed it — option to purchase or sell a stock at a certain price over a certain period. Options are derivative financial instruments, which means they are based on an underlying asset. Vanilla options are the most basic type of option contract, and they’re often standardized and traded on exchanges.

Vanilla Option Definition

Vanilla options, in contrast to exotic options, which have customization features, have simple and straightforward terms of the strike price, or the price for which an investor buys or sells a stock, and the period in which they can exercise their option. The last day that an investor may exercise an option is known as the expiry date.

How Do Vanilla Trades Work?

Let’s look at how options trading works with vanilla trading.

Each option has a strike price. If that price for purchase is lower than the market value of the stock, investors call that option “in the money.”

Investors pay a premium to own an option. This premium reflects several factors, including:

• How close the strike price is to the market price

• The stock’s volatility

• How length of time before the option expires

Investors don’t have to wait until the option expires to complete the trade, and they are typically under no obligation to exercise the option.

What are the Different Types of Vanilla Options?

When it comes to options for vanilla stock options, there are two types, calls and puts.

Calls

A vanilla call option gives an investor the option to buy an asset at a certain price within a certain period. A call option is a bit like a down payment; the investor pays the premium so that, later, they can buy the stock at a good price and profit from it.

However, an investor can pay the premium and never exercise the option. If they decided not to exercise it, they would either lose what they paid for the premium, or they could sell the call option to someone else before it expires.

Puts

In contrast, a put option allows an investor to sell an asset at a fixed price within a certain time period. If a stock tanks in value over the period that option is exercisable, the investor can still sell it for the put price and not lose as much of his investment. But if the stock’s value goes higher than the put price in the market, the vanilla options are worthless because the investor could sell it at the market price and realize more of a profit.

Characteristics of Vanilla Options

Like all investments, vanilla options include a level of risk and volatility. But they can also provide the opportunity for profit.

Premiums

Whether you are interested in a vanilla call or put, you will pay a premium, in addition to what you would pay to purchase the stock with a call. The premium isn’t refundable, so if you don’t exercise the option, you’ve lost what you paid for the premium.

Volatility

The volatility of an option determines its price. The higher the volatility of the option, the higher the premium because there is more opportunity for profits (as well as the risk of loss).

One way to reduce volatility is to use an options trading straddle where you buy a put and call option simultaneously.

Risk Level

Like most other types of investments, options are not without risk. If a stock is lower in price on the market than a call option, the option is worthless. And if a stock has a higher price on the market, the put option won’t net more return on investment.

However, a vanilla option may be less risky than buying a stock outright, since the only thing you’re guaranteed to spend is the premium.

Pros and Cons of Vanilla Options Trading

Trading vanilla options can have potentially great returns…or large losses. Here are the pros and cons.

Pros	Cons
Minimizes risk; no obligation to exercise	Risky; may lose premium investment and more
Option to control more shares than buying them outright	May be complex to understand
May offer large returns	Fluctuations in market may render option worthless

Pros

Options may be less risky than buying a stock outright, since you’re only buying the option to purchase or sell a stock at a certain price. The premium is all you invest initially.

Typically you can purchase more shares through options than you could buying them on the market, so if you’re looking for larger investment opportunities, options could provide them.

And while they’re volatile, there is the potential for larger returns.

Cons

That being said, you don’t always see large returns. You can lose your entire investment if the option is out of the money when it expires.

Options can be complicated or confusing for new investors. Not only should you fully understand the risks you take with this investment tool, but you also should understand options taxation.

Examples of Vanilla Options

If you’re considering vanilla options as part of your options trading strategy, here are a few examples to illustrate how they work for both calls and puts.

Example of a Vanilla Put Option

A put is a bit like insurance in case your stock you’re holding goes down in value. It’s one way that investors might short a stock. Here’s an example.

Let’s say you own 100 shares of a stock that is currently trading at $25 per share. You buy a put option at a premium of $1 per share that expires in two months at a strike price of $25. So in total, you paid $100 for a premium for 100 shares.

In a month, the stock price drops to $18 per share. This is a good time to exercise that premium because your strike price allows you to sell the shares for $25 rather than $18. You wouldn’t gain any money because you’re essentially selling the stocks for what you paid for them ($25), and you would even lose a little (that $1 per share premium), but the alternative would be to lose even more if you waited and the price dropped more or you didn’t have the option.

Example of a Vanilla Call Option

A call option allows you to purchase a stock at a certain price within a specified time period. Bullish investors who expect a stock to go up in price typically purchase call options.

For our example, let’s say you’re interested in a stock that trades at $53, and you can buy a call option for this stock within one month to purchase the stock at $55 per share. The option is for 100 shares of this stock.

The premium for this option is $0.15 per share. So you would pay $15 for the premium. You aren’t obligated to purchase the stock. If the stock trades at more than $55.15 (option price plus premium), you can realize a profit.

Let’s say in two weeks, that stock is trading at $59. It is, as they say, “in the money.” Now would be a great time to exercise your option because you can realize $3.85 per share and $385 for 100 shares. You can sell the shares immediately to cash in on that profit or hold onto it to see if the stock price continues to rise.

The Takeaway

Vanilla stock options can be a way to diversify your investment portfolio and increase your investing savvy. When it comes to options trading, it helps to have a platform like SoFi’s, which boasts an intuitive design. Plus, you’ll have access to educational resources to learn about any other terminology that comes up on your options trading journey.

Trade options with low fees through SoFi.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Sep

2021

What is MANA (Decentraland Coin)? How to Buy MANA

By Matthew Zeitlin | Growing Wealth, invest, Investing | Comments Off

There are layers to cryptocurrency. Services, products, even nascent legal systems can be built on top of and within blockchains. For example, a whole range of cryptocurrency types are built on Ethereum and its blockchain, including something that combines services, products, and legal system — in fact, it’s a whole virtual world.

That’s the idea behind LAND, a non-fungible token (NFT) that’s the basis of the “land” in Decentraland, a virtual game world built on cryptocurrency. To get LAND you need MANA, the cryptocurrency of Decentraland — and quite literally the coin of the realm. Except this realm is governed by…well not by any one person exactly. After all, it’s Decentraland, not Centraland.

What is Decentraland (MANA)?

MANA is the currency that is used in Decentraland . Decentraland is made up of LAND, non-fungible digital plots of virtual space (or land) that make up the game. The developers of Decentraland created a fixed amount of land, encouraging users to “develop” what they have and thereby creating a market for the currency used to transact with it, MANA. Also, because LAND is a type of NFT, any individual parcel can not be replicated or duplicated. LAND first went up for sale in December, 2017 and since January the land has been owned by “participants” in Decentraland.

LAND isn’t the only asset available within the Decentraland universe — one can also buy virtual goods using MANA in the Decentraland Marketplace. These include “wearables” like virtual clothing as well as names that are unique within Decentraland.

MANA Price

As of late September 2021 the price of MANA was around 70 cents.

Like many cryptocurrencies, the value of MANA is quite volatile, with the price changing substantially over time. Anticipating and dealing with the rapid and extreme change in prices is one of the basics of investing in crypto.

According to CoinMarketCap , MANA is the 78th most valuable cryptocurrency with a “market cap” or total value of just under $1.2 billion. Like many cryptocurrencies, MANA shot up in price earlier this year, jumping from 25 cents to just over a dollar in less than a month starting in late February. It fell and rose again, getting as high as $1.57 in early May.

History of Decentraland

The Decentraland white paper — the official founding document of the cryptocurrency that explains its purpose and the technical specifications for it — was published in early 2017, several months before the virtual universe and its MANA cryptocurrency came into being.

The main idea behind Decentraland is that thanks to the proliferation of cell phones and computers, many people are in a kind of “virtual world” most of the time anyway. Decentraland positions itself as a 3D as opposed to 2D interface.

True to the ethos of cryptocurrency that animates everything from how Bitcoin mining works to the skepticism around some crypto regulations, let alone crypto taxes, another animating concept behind Decentraland was that as opposed to other virtual worlds — think Second Life, World of Warcraft, Fortnite — there would be no central authority in charge of it.

The group behind the white paper got started in 2015 and started working on a 2D grid that they referred to as Decentraland’s “Stone Age”. Another prototype was the “Bronze Age” and the public launch would be its “Iron Age”. Soon after the white paper, Decentraland was able to raise over $20 million in an initial coin offering.

A total of 2.8 billion MANA tokens have been in circulation since September 2017. There’s a maximum total supply of about 2.2 billion MANA coins; this, combined with the fixed amount of LAND tokens, is designed to avoid runaway or unpredictable devaluation of the assets within Decentraland, as can be an issue with other “currencies” like airline miles, for example. Instead of devaluation through inflation, there’s actually been some increased valuation of MANA through deflation.

How Does the MANA Coin Work?

The MANA coin works as a token on the Ethereum blockchain. This means that the Decentraland token MANA requires Ethereum and its token, Ether, to be purchased and exchanged.

To do this, the first step is connecting your crypto wallet holding Ether to the Decentralized marketplace . Once you exchange Ether for MANA, you can then use MANA to purchase items within Decentraland, including parcels of land.

How and Where to Buy MANA Crypto

There are a few different ways to buy MANA — both of which will be familiar to anyone who’s looked into investing in most other types of crypto.

Centralized Exchange

On a central exchange, you can swap your fiat currency like U.S. dollars for a crypto coin, which is then stored using a crypto wallet. The following exchanges offer MANA:

• Coinbase

• Gemini

• Binance

• Kraken

• Gate.io

Decentralized Exchange

You could also purchase MANA by purchasing Ether tokens through brokers or exchanges and then swapping for MANA. It’s possible to buy MANA in this way from:

• SoFi Invest

• Kyber

The Takeaway

Decentraland has created an entire virtual world where participants can use the cryptocurrency MANA to buy parcels of LAND, an NFT that represents actual land in that world. One can also use MANA to buy and sell goods and services within Decentraland — like virtual clothing — on the Decentraland marketplace.

For investors looking to trade crypto, SoFi Invest® offers a range of cryptocurrencies including Ethereum, Bitcoin, Litecoin, Cardano, Dogecoin, and more.

Find out how to start trading crypto with SoFi Invest.

Photo credit: iStock/RichVintage

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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Sep

2021

Guide to Options Prices: How are Options Priced?

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

Options are derivative financial instruments that give the buyer the right (but not the obligation) to buy or sell an underlying security, such as a stock, within a predetermined time period for a predetermined price, known as the strike price.

Investors like options because they allow the investor to bet on the price increase or decrease of a stock, without owning the stock itself. There are two main types of options: call options and put options. An investor who buys a call option buys the right to buy the option’s underlying asset. An investor who purchases a put option is buying the ability to sell the option’s underlying asset.

Recommended: A Guide to Options Trading

How is an Option Price Determined?

The sellers of an option take many different factors into account to determine the price, or premium, of an option. The most widely known method for determining the value of an option is the Black-Scholes model. But other models – such as the binomial and trinomial options pricing models – are more commonly used to determine stock option prices.

All of those options pricing models are complex, but they all draw on a few primary factors that drive the investment value of an options contract:

• the market price of the stock that underlies the option

• the current intrinsic value of the option

• the time until the option expires

• volatility

Market Price and Intrinsic Value

The first is easy to understand – it’s the price at which the underlying stock is trading. The second – the intrinsic value of the option – is the value of the option would be worth if sold at that moment. This only applies if the price of the underlying stock has moved to where the option is “in the money,” meaning the owner of the option would make a profit by exercising it.

Time Value

The time until expiration is more complex. It represents the possibility that an out-of-the-money option could eventually become profitable. This so-called time value reflects the amount of time an option has until it expires. It’s one part of an option’s value that only goes down – and which goes at an increasingly rapid rate as the options contract approaches expiration. As the expiration date gets closer, the underlying stock must make bigger moves for those price changes to make significant changes in stock options pricing.

Volatility

That time value reflects the volatility of the underlying security, as well as the market’s expectation of that security’s future volatility. As a general rule, stocks with a history of high volatility underlie options that with a higher likelihood to be in-the-money at the time of their expiration.

Volatility, in many pricing models, is represented by beta, which is the volatility of a given stock versus the volatility of the overall market. And options on stocks with higher historic or expected volatility typically cost more than options contracts on stocks that have little reputation for dramatic price swings.

What Are the Different Option Pricing Models?

There are several models that investors and day traders consider when figuring out how to price an option. Here’s a look at a few of the most common:

The Black-Scholes Merton (BSM) Model

The best-known options pricing method is the Black-Scholes model. The model consists of a mathematical formula that can be daunting for people without a math background. That’s why both institutional and retail investors employ online options calculators and analysis tools.

The economists who created the formula published their findings in 1973, and won the 1997 Nobel Prize in economics for this new method for arriving at the value of financial derivatives.

Also known as the Black-Scholes Merton (BSM) model, the Black-Scholes equation takes the following into account:

• the underlying stock’s price

• the option’s strike price

• current interest rates

• the option’s time to expiration

• the underlying stock’s volatility

In its pure form, the Black-Scholes model only works for European options, which investors can not exercise until their expiration date. The model doesn’t work for U.S. options, because U.S. options can be exercised before their expiration date.

The Binomial Option Pricing Model

The Binomial Option Pricing Model is less well-known outside of financial circles, but it’s more widely used. One reason it’s more popular than the Black-Scholes Model is that it can work for U.S. options. Invented in 1979, the binomial model reflects on a very simple assumption – that in any pricing scenario the premium will go one of two ways: up or down.

As a method for calculating an option’s value, the binomial pricing model uses the same basic data inputs as other models, with the ability to update the equation as new information emerges. In comparison with other models, the binomial option pricing model is very simple at first, but it becomes more complex as investors take multiple time periods into account. For a U.S. option, which the owner can exercise at any point before it expires, traders often use the binomial model to decide when to exercise the option.

By using the binomial option pricing model with multiple periods of time, the trader has the advantage of being able to better visualize the change in the price of the underlying asset over time, and then evaluate the option at each point in time. It also allows the trader to update those multi-period equations based on each day’s price movements, and emerging market news.

Recommended: What Is a Straddle in Options Trading?

The Trinomial Option Pricing Model

The trinomial option pricing model is similar to the binomial model but it allows for three possible outcomes for an option’s underlying asset within a given period. Its value can go up, go down, or stay the same. As they do with the binomial model, traders recalculate the trinomial pricing model over the course of an option’s life, as the factors that drive the option’s price change, and as new information comes to light.

Its simplicity and acknowledgement of a static price possibility makes it more widely used than the binomial option pricing model. When pricing exotic options, or any complex option with features that make it harder to calculate than the common calls and puts on an exchange, many investors favor the trinomial model as a more stable and accurate way of understanding what the price of the option should be.

The Takeaway

Understanding how options pricing works is important, whether you’re interested in trading options or not. However, you can also build a more straightforward portfolio that does not use options at all.

A great way to get started is with SoFi’s options trading platform. The platform has an intuitive design where you can trade options on the mobile app or through the web platform. You’ll also have access to educational resources to continue to help guiding you along the way.

Pay low fees when you start options trading with SoFi.

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