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Understanding How Options Are Priced
You might have had success beating the market by trading stocks using a disciplined process anticipating a nice move either up or down. Many traders have also gained the confidence to make money in the stock market by identifying one or two good stocks posed to make a big move soon. But if you don’t know how to take advantage of that movement, you might be left in the dust. If this sounds like you, maybe it’s time to consider using options. This article will explore some simple factors to consider if you plan to trade options to take advantage of stock movements.
- Options contracts can be priced using mathematical models such as the Black-Scholes or Binomial pricing models.
- An option’s price is made up of two distinct parts: its intrinsic value and its time (extrinsic) value.
- Intrinsic value is based on an option’s in-the-moneyness and is relatively straightforward to compute.
- Time value is based on the underlying asset’s expected volatility and time until the contract’s expiration and is far more complex to calculate.
Before venturing into the world of trading options, investors should have a good understanding of the factors determining the value of an option. These include the current stock price, the intrinsic value, time to expiration or the time value, volatility, interest rates, and cash dividends paid.
There are several options pricing models that use these parameters to determine the fair market value of an option. Of these, the Black-Scholes model is the most widely known. In many ways, options are just like any other investment—you need to understand what determines their price to use them effectively. Other models are also commonly used such as the binomial model and trinomial model.
Let’s start with the primary drivers of the price of an option: current stock price, intrinsic value, time to expiration or time value, and volatility. The current stock price is fairly obvious. The movement of the price of the stock up or down has a direct, although not equal, effect on the price of the option. As the price of a stock rises, the more likely it is that the price of a call option will rise and the price of a put option will fall. If the stock price goes down, the reverse will most likely happen to the price of the calls and puts.
Understanding Option Pricing
Intrinsic value is the value any given option would have if it were exercised today. Basically, the intrinsic value is the amount by which the strike price of an option is in the money. It is the portion of an option’s price not lost due to the passage of time. The following equations can be used to calculate the intrinsic value of a call or put option:
The intrinsic value of an option reflects the effective financial advantage resulting from the immediate exercise of that option. Basically, it is an option’s minimum value. Options trading at the money or out of the money, have no intrinsic value.
For example, let’s say General Electric (GE) stock is selling at $34.80. The GE 30 call option would have an intrinsic value of $4.80 ($34.80 – $30 = $4.80) because the option holder can exercise his option to buy GE shares at $30, then turn around and automatically sell them in the market for $34.80—a profit of $4.80.
In a different example, the GE 35 call option would have an intrinsic value of zero ($34.80 – $35 = -$0.20) because the intrinsic value cannot be negative. Intrinsic value also works the same way for a put option. For example, a GE 30 put option would have an intrinsic value of zero ($30 – $34.80 = -$4.80) because the intrinsic value cannot be negative. On the other hand, a GE 35 put option would have an intrinsic value of $0.20 ($35 – $34.80 = $0.20).
The time value (or, extrinsic value) of options is the amount by which the price of an option exceeds the intrinsic value. It is directly related to how much time an option has until it expires, as well as the volatility of the stock. The formula for calculating the time value of an option is:
T i m e V a l u e = O p t i o n P r i c e − I n t r i n s i c V a l u e Time\ Value = Option\ Price-Intrinsic\ Value T i m e V a l u e = O p t i o n P r i c e − I n t r i n s i c V a l u e
The more time an option has until it expires, the greater the chance it will end up in the money. The time component of an option decays exponentially. The actual derivation of the time value of an option is a fairly complex equation. As a general rule, an option will lose one-third of its value during the first half of its life and two-thirds during the second half of its life. This is an important concept for securities investors because the closer you get to expiration, the more of a move in the underlying security is needed to impact the price of the option. Time value is often referred to as extrinsic value.
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Time value is basically the risk premium the option seller requires to provide the option buyer the right to buy/sell the stock up to the date the option expires. It is like an insurance premium for the option; the higher the risk, the higher the cost to buy the option.
Looking again at the example from above, if GE is trading at $34.80 and the one-month-to-expiration GE 30 call option is trading at $5, the time value of the option is $0.20 ($5.00 – $4.80 = $0.20). Meanwhile, with GE trading at $34.80, a GE 30 call option trading at $6.85 with nine months to expiration has a time value of $2.05. ($6.85 – $4.80 = $2.05). Notice the intrinsic value is the same, the difference in the price of the same strike price option is the time value.
An option’s time value is also highly dependent on the volatility the market expects the stock to display up to expiration. For stocks not expected to move much, the option’s time value will be relatively low. The opposite is true for more volatile stocks or those with a high beta, due primarily to the uncertainty of the price of the stock before the option expires. In Figure 1 below, you can see the GE example already discussed. It shows the trading price of GE, several strike prices, and the intrinsic and time values for the call and put options.
General Electric is considered a stock with low volatility with a beta of 0.49 for this example.
Teucrium Wheat (WEAT)
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Teucrium Wheat Options Chain
WEAT Call 4.00 Exp: Apr 05, 2020 Last: 0 Chg.: 0
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|Price @ Apr 03, 2020 06:35PM GMT|
WEAT Call 6.00 Exp: Apr 05, 2020 Last: 0 Chg.: 0
WEAT Put 6.00 Exp: Apr 05, 2020 Last: 0 Chg.: 0
WEAT Call 7.00 Exp: Apr 05, 2020 Last: 0 Chg.: 0
WEAT Put 7.00 Exp: Apr 05, 2020 Last: 0 Chg.: 0
WEAT Call 8.00 Exp: Apr 05, 2020 Last: 0 Chg.: 0
WEAT Put 8.00 Exp: Apr 05, 2020 Last: 0 Chg.: 0
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What’s the best bread for people with diabetes?
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Bread is a popular food and a key element of the diet in many countries around the world. Bread is often high in carbohydrate, so people with diabetes may wonder if they can still eat it.
The good news is that most people can eat bread unless a doctor advises otherwise. However, it should be the right kind of bread.
Whole-grain breads with high-fiber ingredients, such as oats and bran, are usually the best option for people with diabetes.
Making bread at home with specific, diabetes-friendly ingredients may also help reduce the impact that bread can have on blood sugar levels.
Share on Pinterest In moderation, wholegrain bread can be healthful for people with diabetes.
There are two main types of diabetes, type 1 and type 2.
According to the Centers for Disease Control and Prevention (CDC), more than 30 million people have diabetes in the United States, and 90 to 95 percent of them have type 2.
Type 1 diabetes happens when the body cannot produce insulin, a hormone that “captures” blood sugar (or glucose) and transfers it into cells. Glucose is the preferred energy source for cells.
Type 2 diabetes is the most common form of diabetes. This is also the easier form to prevent and manage with lifestyle changes and medication. Taking measures to control blood glucose levels in the early stages can help prevent this condition from progressing to diabetes.
Poor diet, genetic factors, and lifestyle habits contribute to the development of type 2 diabetes.
Nutrition plays a crucial role in diabetes control. Proper dietary planning, lifestyle choices, and medication can help a person manage their blood sugar levels.
Carbohydrate is one of the three major nutrients essential to human health.
However, carbohydrates also raise blood sugar and can reduce effective diabetes control. This is mainly because carbohydrates break down into blood sugar.
The key to keeping blood sugar in check after a meal is to choose food items that contain quality carbohydrates. Quality carbohydrates are those that rate low or medium on the glycemic index.
The glycemic index is a measurement of individual foods and their effects on blood sugar. The three basic categories of the glycemic index (GI) are low, medium, and high.
What is the glycemic index?
The American Diabetes Association (ADA) explain that the GI compares the way foods raise blood sugar levels compared with a reference food, usually glucose.
Glucose is a reference point for the GI with a score of 100. White bread would score around 71.
Foods that do not contain carbohydrates, such as meats and fats, do not have a GI score.
Low-glycemic foods score 55 or less and include:
Medium-glycemic foods score 56 to 69 and include:
High-glycemic foods score 70 or more and include:
The more processed or cooked a food is, the more likely it is to have a high GI.
Commercially-produced white bread is high on the GI index, but wholemeal bread can be lower on the GI scale.
The first step in choosing a suitable bread is to opt for bread made with wholemeal or stone-ground flour. The less processed the flour, the lower the GI score will be.
Reduce the sugar content
When bread uses yeast to rise, it usually needs some sugar to “feed” the yeast.
Some commercial breads contain more sugar than is necessary to make the bread rise.
If you make bread at home, whether by hand or in a bread-making machine, you can experiment with smaller amounts of sugar.
Ingredients to add
If you are making bread at home, you can add ingredients that lower the GI score.
High-fiber, high-protein, and high-fat ingredients may be important additions to reduce the impact the bread has on blood sugar.
These ingredients include things like:
One idea is to replace one-fourth of regular flour with an equal proportion of the other, more healthful ingredients.
For example, if a favorite bread recipe calls for 2 cups of flour, you can replace half a cup of flour with half a cup of flaxseed meal.
Swapping out all-white flour for whole-wheat bread or pastry flour is also a good idea.
Serving the bread
You can reduce the GI score further by choosing spreads carefully, for example, using unsweetened peanut butter or avocado instead of jellies and chocolate spread.
Recipes for bread and other foods that are suitable for diabetes are available to purchase online.
Most commercially-available breads contain refined, white flour. This contains no fiber, and it can cause blood sugar to rise.
Even “wheat bread” may be made with refined wheat and not whole grain.
Some brands that identify their bread as “seven grain” or “nine grain” only use those grains on the crust, while most of the bread still consists of refined white flour.
Being aware of the packaging and labeling of breads can help people with diabetes choose a suitable product.
Here are four types of breads that may be healthier options for diabetes control:
Fiber-enriched whole-grain bread
Fiber is a type of carbohydrate that the body cannot digest. It keeps bowels regular and helps to promote a feeling of fullness. Fiber can also help control blood sugar.
Studies have shown that soluble fiber can slow the rate of digestion and reduce the rise in blood sugar after eating.
This is why fiber is said to lower the GI score of a food.
Adding soluble fiber to breads may help a person manage blood sugar.
However, fiber-enriched whole-grain breads are still relatively high in carbohydrates, so it is important to eat them in moderation.
A person should also consume breads alongside a regime of exercise and other healthful life choices.
Multi-grain sandwich bread
A multi-grain bread is high in carbohydrates but it tends to contain whole, unrefined grains that are high in naturally occurring fiber. This can help lessen the impact of carbohydrates on blood sugar.
When choosing whole-grain bread, people should find one that includes ingredients such as oats, quinoa, buckwheat, whole-grain wheat, brown rice, bran, and barley.
Whole grains have a lower GI score than wheat flour, and many grains contain other nutrients, such as zinc, vitamin E, and protein.
Tortillas can provide a tasty, versatile, and sometimes healthier choice for sandwiches.
Manufacturers are increasingly providing a wider range of low-carbohydrate tortillas to appeal to health-conscious consumers.
Many of these low-carbohydrate tortillas have added fiber to reduce the carbohydrate count. Some tortillas contain low-carbohydrate ingredients, such as whey and soy protein powders.
People can use low-carbohydrate tortillas as they would use bread, wrapping their favorite sandwich ingredients in the tortilla. You can also use tortillas for mini pizzas, homemade burritos, and tacos.
Perhaps the best choice for diabetes-friendly bread is one that contains no flour or grains.
Flourless sprouted-grain breads are available, and they are a good source of fiber. However, they are still rich in carbohydrates.
Specialty health food stores may sell grain-free breads made with ingredients like almond flour, coconut flour, and flaxseed meal. Check the nutrition facts however, since they may also be higher in calories.
Many recipes for making grain-free bread are available on the Internet.
A search term like “grain-free bread recipe” will bring up some low-carbohydrate bread recipes.
These breads tend to be more expensive to make and often yield a smaller amount compared with traditional bread recipes.
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