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Notes on Option Volatility and Pricing (by Natenburg)

Before I begin I would like to make sure that you know what an option is because they can be a little strange compared to stocks. I like to think of them as stocks with insurance, but where there is a winner, there is always a loser. There are two types, a call option and a put option, trading them on an exchange is known as futures.

• Call option example:
  (The right to buy) A current stock price is $100. The seller gives you the right to buy 10 shares of the stock for $103 anytime in the next month, but you pay a premium for each share, say $2. At this point you pay $20 for the contract and need a break even point, calculated by 10*103 + 20 = 1050. Therefore, if the share price goes past $105, you make the trade!
  
• Put option example:
  (The right to sell) A current stock price is $100. The buyer gives you the right to sell 10 shares of the stock for $97 anytime in the next month, but you pay a premium for each share, say $2. At this point you pay $20 for the contract and need a break even point, calculated by 10*97 - 20 = 950. Therefore, if the share price goes down past $95, you as the seller now buys the cheaper stock on the market and then sell it via the contract!
  
  

Chapter 1 – Financial Contracts

• Spot or Cash Transaction – both partners agree on terms, followed immediately by an exchange of money for goods.
• Forward Contract – Goods to be exchanged at a later date.
• Expiration Date or Maturity¬ – End of contract period.
• Futures Contract – When a forward contract is traded on an organized exchange.
• Option Contract – Both parties agree to a forward contract with a premium.
• Call Option – the right to decide at a later date whether to buy.
• Put Option – Gives one party the right to sell at a later date.
• Exercise Price – How much the buyer of a policy (insurance) will receive if event occurs.
• Derivative Contracts – forwards, futures, and options contracts.
  

Buying and Selling

• Open Interest – the number of contracts traded on an exchange that have not yet been closed.
• Long and Short – If a trader first buys a contract (an opening trade), he is long the contract. If the trader first sells a contract (also an opening trade), then he is short the contract. Long and short refer to the act of making as either going long (buying) or going short (selling).
• Diagram
  
  
  
• Long trader wants market to rise.
• Short trader wants market to fall.
  

Notional Value of a Forward Contract

• Notional Value or Nominal Value – Number of units times unit price.
  

Settlement Procedures

• Realized Profit – Finishing the cycle above, otherwise no profit is made.
• Margin Deposit – The deposit made to trade futures (tax, I like to call it).
• Futures-type settlement, where there is an initial margin deposit followed be daily cash transfers, is also known as margin and variation settlement.
• Physical Settlement – when a trader holds it to maturity.
  
  
  
• Note: They are using the previous current position because that is how much worth their position was that day when futures were sold.
  

Market Integrity

• Clearinghouse – Assumes ultimate responsibility for ensuring the integrity of all exchange-traded contracts.
• Clearing Firm – The clearinghouse is made up of these. Processes trades made by individual traders and agrees to fulfill any financial obligation arising from those trades.
• The Clearing Process:
  
  

Source:

Natenberg, Sheldon. Option Volatility and Pricing Advanced Trading Strategies and Techniques. 2nd ed., McGraw-Hill Education, 2015.

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