Crash Market Stock

Parity - When we discuss parity in terms of options, we say that parity is the amount by which an option is in the money. Parity refers to the option trading in unison with the stock. This also indicates that parity and intrinsic value are closely related. When we say that an option is trading at parity, we mean that the option’s premium consists of only its intrinsic value.

For example, if the shares in Microsoft were trading at $53.00 and the January 50 calls were trading at $3.00, then the January 50 calls are known to be trading at parity. Under the same guidelines, the January 45 call would be trading at parity if they were trading at $8.00. So, parity for the January 50 calls is $3.00 while parity for the January 45 calls is $8.00

Now if these calls were trading for more than parity, the amount (in dollars) over parity is called ‘premium over parity.’ Thus, the term ‘premium over parity’ is synonymous with extrinsic value, which was discussed above.

If, for example, the stock is trading at $53.00 and the January 50 calls are trading at $3.50 then we would say that the calls are trading at $0.50 over parity. The $0.50 signifies the premium above parity that is also the sum of extrinsic value. The $3.00 is the sum of intrinsic value or parity.

The term time decay is defined as the rate by which an options extrinsic value decays over the life of the contract.

Volatility is defined as the degree to which the price of a stock or other underlying instrument tends to move or fluctuate over a period of time.

Implied Volatility is a value derived from the option’s price. It indicated what the market’s perception of the volatility of the stock or underlying will be during the future life of the contract.

A stock that has a wide trading range (moved around a lot) is said to possess a high volatility. A stock that has a narrow trading range (does not move around much) is said to have a low volatility.

The significance of volatility is that it has the principal effect on the amount of extrinsic value in an option’s price. When volatility rises (increases), the extrinsic value of both the calls and the puts increase. This makes all the option prices more expensive. When volatility goes down (decreases), the extrinsic value of both the calls and the puts decrease. This makes all of the option prices cheaper.

As stated earlier, a call option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right, but not the obligation, to purchase a specified stock or other underlying instrument, at a predetermined price on or prior to a specified date.

The seller of a call option assumes the obligation of delivering the stock or other underlying instrument to the buyer should the buyer wish to exercise his option.

The call is recognised as a long instrument, which actually means the buyer gains from the stock going up, and the seller wants the stock to go down or remain the same. For the buyer to gain a profit, the stock should move above the strike price plus the sum of money spent to purchase the option.

This point is usually known as the breakeven point and is calculated by adding the strike price of the call to its premium. While the buyer hopes the stock price exceeds this point, the seller hopes that the stock stays below the breakeven point.

The buyer of the call has limited risk and unlimited potential gain. His risk is restricted to only to the amount of money he spent in buying the call. His unlimited potential gain comes from the stock’s upside growth potential.

The seller, on the other hand, has limited potential gain and unlimited potential loss. The seller can only gain what he was paid for the call. His unlimited risk comes from the stock price’s ability to rise during the life of the contract.

The seller is responsible for delivering the stock to the buyer at the strike price regardless of the present market price of the stock. This is specifically why the seller gets a premium for the sale. It is reward for taking on this risk.

For example, if a seller sold the MSFT January 65 call for $2.00, he is giving the buyer the right to buy 100 shares (per contract) of MSFT from him for $65.00 per share at any time until the option expires.

If MSFT rallies and trades all the way up to $75.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00). Meanwhile, the buyer would realize a $10.00 profit minus the amount he paid for the option ($2.00).

If MSFT were to trade, for example, down to $55.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). In the meantime, the buyer would only lose what he paid for the option ($2.00).

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