Hello, everyone, and welcome to Schwab Coaching. My name is Cameron May. I'm a senior manager here at Schwab, and this is Getting Started With Options. This is the fifth lesson in our series of 10 lessons that are intended to help someone really along that learning curve on their first learning about the world of options trading, and this is a big one. I'm really looking forward to this discussion. We're going to be talking about the vital role that options pricing and the Greeks play in the ultimate success or failure of an individual trader, maybe for an options trading career. If you'll forgive me, I was thinking this morning as I was preparing for this about, you know the social media influencers who have their phone out and they're showing a stock chart going straight up, 'buy here' and 'sell there', and it's that easy?
Well, for a stock investor, they're actually not that far off. Now, that's kind of a classic case of easier said than done, but yeah, with stock trading or investing, the basic concept is buy low and sell high, and it's not that easy. It's price that drives a lot of either the profitability or failure of a trade. With options trading, it's a little bit more complicated. There are actually three big drivers of options pricing. We're gonna be talking about how options can make money and how options can lose money. That's a good topic. We'll set a more precise agenda for the accomplishment of that in just a moment. Let me first of all say hello to everybody who's out there in the chats. Great to see Will and Dragon Rider, Austin, Lena, Jim, Sharon, Ted, Ahmad, Eva, everybody else.
Thanks for joining us week after week. We really do appreciate your attendance, your contributions to these discussions. We really hope that you've enjoyed lessons one through four. If you're here for the very first time, though, I wanna welcome you as well. And if you're watching on the YouTube archive after the fact, enjoy the presentation, but be aware that you're invited to join us in the live discussion. This is a Tuesday webcast series, kicks off promptly at noon Eastern. We'd love to have you in the live stream. And I also wanna let everybody know that we have my very good friend, Connie Hill, another one of our great educators, hanging out in the chats with the live stream audience. Connie's gonna be addressing any questions that I can't get to.
As long as they're not too far off track, Connie will be there to pick up the slack for me if I can't get to that question myself. So thanks for having my back there, Connie. And Connie and I would also like to issue an invitation to everybody watching. If you're not following us on X, please do. That's the best place to connect with your favorite presenters. So if you have an X account, just go follow us. You can follow Connie at ConnieHillCS. You can find me on X at CameronMayCS. But let's get into this. The vital role of options pricing and the Greeks, lesson five of 10. As we do, of course, we first need to pause to consider the risks associated with trading and investing. It certainly applies to options trading as well.
Options carry a high level of risk and are not suitable for all investors. The information here is for general informational purposes only. It should not be considered an individualized recommendation or endorsement. It should not be considered an individualized recommendation of any particular security, chart pattern, or investment strategy. Schwab does not recommend the use of technical analysis as a sole means of investment research. And investing involves risks, including the loss of principle. Okay, so here's where we are in our series. Lessons one through four, we were acquainting ourselves with the four basic building blocks of every strategy out there in options trading. With options trading, there are calls and there are puts, and you can either buy or sell them.
So we went through those, those four different combinations to set the stage for the webcasts that are going to be coming up in lessons six through nine, which is building combination strategies, combining those building blocks. So if you haven't caught those, make sure that you go back and watch lessons one through four. But today is all about options pricing and Greeks. And here's what we're going to be doing today. First thing we're going to do is go put ourselves in the shoes of a theoretical options trader out there, and we're going to buy a long call option. Then we're going to gauge, we're going to learn how the current price of that option was established. And we're going to learn what might influence that price to either go up or down from the time we bought it.
There are going to be three major influences, along with a few others to consider that can contribute to the ultimate success or the failure of that trade. And that's going to include a discussion of what we call the options Greeks. Now that can be kind of an intimidating term. It's going to sound like we're learning a new language. There might be a few new terms to understand, but I'll tie them into the discussion of options pricing as clearly and concisely as I can. And so we can really understand the implications and the real assist that the Greeks can be to hopefully anticipate the changing future values of an options trade when we're thinking about getting into one. Okay, so that's it. Place a trade, learn how the trade is priced and how it might make or lose money.
That's it. So let's go right to Thinkorswim. And I want to start with just this view of Walt Disney. Now I'm using the Thinkorswim desktop trading software platform. And if you haven't downloaded this, you can download it for free from within your Schwab online account. Just go to the trade tab, find where it says thinkorswim in the dropdown menu in the trade tab. And you can download, follow the online prompts right from there. There'll be a big blue button. You can't miss it. They'll teach you more about promoting thinkorswim and it'll help you through that process. And then just log in using your Schwab ID and you'll find yourself on this platform. And I've just gone to the charts and I've loaded up Disney.
And I just want to make a very basic chart case for someone buying a long call. Janelle says it's the best platform ever. Some people have that opinion. Now I can't say how everybody's going to feel about the platform. Am I a fan of it? Yeah, I've been using it for a long time. I think Mike says 'Greeks are Greek' to him. Hopefully they're not going to be, but let's just say that our trader here has noticed, you know, Walt Disney has been beaten up in recent years. It's actually not trading too terribly far above 10-year lows, but recently started to gain some strength, pushed up through a previous price floor. Maybe that'll act as a new floor again. And then just yesterday, we got a big white candle popping up up above.
Let's say that our trader is thinking that one 10 level might be a new price floor. And maybe that's the stock is set to go higher from here, possibly up to these previous highs, maybe even further on a longer term basis. You can see how far down this stock is. Now, whether it actually does that or not, time will tell, but let's suppose that our trader decides, well, let me go buy a long call, maybe two or three months worth of time. See if I can let this thing run. So let's go to our trade tab. And I'm not going to spend much time on the selection of a long call. If you need to learn more about that, you can go right back to lesson one, where we talked about trading long calls in greater detail.
But how about we say, we go out here to the 17th of April, that's going to give us at least a couple of months to work with on a contract. I'm going to go to the 17th of April and build just an example trade. Let's say with the stock trading at a 113 ish. How about we buy the one 10 as our example, long call trade today. So let's just jot down the particulars of that. We're going to buy the 17th of April, the one 10 call, and that looks like that's trading for between seven 95 and eight 10 conveniently. Let me just say, we're able to buy that for eight bucks. I'm being maybe a little bit generous there. It might cost us a few more pennies.
I'm going to use a nice round number here to just to keep the learning as simple as I can. So let's say that we're able to do that. To fill that for $8, or in other words, we're spending $800. And just as a quick recap for that $800, we now have for the next 72 days, or through the 17th of April, the right to buy 100 shares of Disney for $110 per share. But I want to focus on this part of the equation that maybe the $8, $8 per share, how did the market come up with that price? Where does that price come from? So that's known as a premium. The $8 is known as a premium. And there is a short equation that describes how that price is determined.
It actually consists of two different elements. That premium, the $8, consists of the intrinsic value. So I'm just going to abbreviate that to intrinsic. Plus the extrinsic value. So let me break that down in more detail using this number. So if we have an $8 premium, first of all, it has what we call intrinsic value. What is that? Well, to calculate that intrinsic value, we just take the current price of the stock when we're dealing with calls, and we subtract the strike price, the $110. So if the stock is at $110, we subtract the strike price, which is also $110. So if the stock is at $113. 15, let's just say right now, I'm going to write that down. $113.
15, because it's going to change as we're talking. And I want a static number to make reference to so that we don't get too distracted by things always changing. It's actually change that we're discussing today. But in any case, we take that $113. 15 current price of the stock and subtract the strike price of the call that we bought. And that tells us, the intrinsic value is $3. 15. Okay, maybe it'll be helpful if I spell that out right here. $3. 15. So why is it $3.15? Well, we know that we have the contractual right to buy shares for $110. Those shares are actually worth $113. 15. So it's like, it's as though we're getting along with this contract, included in this contract, is a current discount on price of $3.
15. It has intrinsic or inherent value. That's what that refers to. And that's just a nice, fixed, easy number. Easy is, I suppose, always in the eye of the beholder. But the equation is fairly straightforward. Current price minus the strike price. Now, sometimes the current price is below the strike price, in which case we have no intrinsic value. So, if we're getting $3. 15 of current, inherent, or intrinsic value with this, why in the world are we spending $8? That, to me, means there's a leftover about $4. 85 that's unaccounted for, right? Let's put this into our equation. $4. 85. We've got to add up to $8. That's the extrinsic value of this contract, sometimes referred to as the time value.
I'm going to put that in quotes, because it's an incomplete description. But yes, some people refer to this as the time value of the contract. But the $4. 85, I want to spend a little bit more time on, because it has a number of influences there. So, what's our extrinsic value? It's $4.85. And whereas we know that the intrinsic value is really just influenced by price. If the price of our stock goes up, that intrinsic value of our option increases, and hey, the option may be worth more money. If the stock price were to fall, let's say, look at this. As a matter of fact, it's falling at the moment. It just slipped below $1. 13. It's now $1. 1289. Which means we now only have $2.
89 of intrinsic or inherent value. So, price is the driver of this. It's either positive or it's zero. Extrinsic value is influenced by three things. So, it does start with time. With this contract, we bought this contract through the 17th of April. It has 72 days on it. With those 72 days, we know that if the stock goes up, and we've given it 72 days where it can go up, the higher that stock goes, the more intrinsic value this contract has, and potentially, the more valuable the contract becomes for the owner. And as a matter of fact, there's an unlimited amount of intrinsic value that that contract can build, especially given sufficient time to do it. So, time definitely plays a role. A shorter-term contract just doesn't carry as much potential.
You know, it might be nice if we walked in a purchase price of $110 for, well, let me just show a more real, a realistic example. These contracts are only for three days. So, if we're walking in a purchase price of $110 for only three days, notice it doesn't cost as much to do that because there's not as much potential inherent to having that contract for three days as there is for 72 days. The more time on the contract, the more valuable the contract can be. And therefore, that does have an influence, on the pricing of the contract. The less time, as time goes by, it chips away at the value of that contract. So, to refer to this extrinsic as time value, yeah, that's a big element, but it's not the only element.
What's the next element? Volatility also certainly contributes here. And by the way, Ted, thank you. Appreciate that. Eva, thanks for calling that out. What Ted and Eva are pointing out here for the live stream audience is that, there is a survey that's been added to the chat window. So, I'll just hit the pause button on the presentation. We'll talk about volatility's role in just a moment here. But, to go to Ted and Eva's point, a survey has been added to the live stream chat. If everyone in the live stream would do me this favor, click on that survey link right now. That'll have the survey ready for you to fill out after the webcast is over. It's a really short survey, two multiple choice questions, and then a comments box and a suggestion box.
Um, promise you, if you take the time to fill out that survey, I take the time to read through those comments and read through that data. It gets sent directly to me with a little summary. So I definitely appreciate it. It helps. Okay. So that's it. Thanks for filling out that survey. Let's get back to the presentation. We're learning right now about how this option is priced. We've learned part of the price is how much intrinsic value the contract has. Part of the price is how much time we have till expiration. Part of that price is also due to volatility. So let's talk through a little bit of a hypothetical scenario here. Let's say that we have two traders buying what appear to be identical contracts, but on different stocks.
So we have trader A, maybe they're looking at Disney and they're buying the 110 strike price for 72 days. And trader B is looking at another stock. Let's say it's also priced at $113. They're also buying a contract for 72 days. They're also locking in a purchase price of 110. It sounds like they should be very similar, but let's say that trader B's contract is for some reason less expensive. And they might think, oh, I've landed on a mispricing of this second contract. No, they haven't. Nope. What's very likely contributing to that lower price is lower anticipated volatility levels for the trader B. So let's say that we have two traders buying a contract. So let's say that we have two traders buying a contract.
So let's say that we have two traders buying a contract. So let's say that we have two traders buying a contract. Here's what I'm talking about. Ahmad says, volatility option or the stock? So Ahmad, that's a great question. Yeah. We're talking specifically about the volatility of the stock. So let's say that our trader in contract B isn't aware that that stock actually hasn't done anything for the last year. Maybe it's gone up to 114 and the next month it goes down to 112, then it goes back up to 114, but trading in a very narrow range, just doing not much of anything. And now they're all excited because they found a cheap contract, less expensive than Disney. Well, what they're really doing is they're buying a stock that nobody's excited about.
They're buying a contract on a stock that nobody's excited about. Maybe the expectation is since this stock has been so quiet for so long, been quiet for a year, what's it likely to do over the next 72 days while we own a call? Boring. The traders might, options buyers are, pretty well-informed group for the most part. And they're willing to pay more for a contract on a stock that is volatile and is expected to be volatile during the timeframe of the contract than on some other one that's just kind of a quiet stock that doesn't do much. Does that make sense? So yes, volatility definitely plays a role in the current pricing of options and in the future pricing of options.
And it's based on stocks that, that, that, typically express greater volatility and where traders expect greater volatility for the timeframe of the contract, the prices are going to be higher. So longer-term contracts on more volatile stocks will tend to be more expensive contracts. Does that make sense? I hope it does. Okay. R. Franklin says you assume open interest might be low as well. Open interest is really just the number of contracts that are open at any specific price, strike price at a given time. Yeah. If it's not very attractive to traders, if it's not heavily traded, it'll have lower interest. Yeah. So volatility plays a role. Now there's one other here. What we've already described are probably the three, what some might call the, the, the Kings of, of options trading or the royalty of options trading-price, time, and volatility usually account for, for the vast majority of the current price in the future.
pricing of options, but there's something else here. And this is where I'm going to give extra bonus points to anybody that can tell me what's another thing that can influence options prices. Maybe not as much as the other three, but it can-interest rates. Let me, let me open this up just a little bit further so we can fit that all in the same line. Yeah. Interest rates can actually affect options prices. So the, the standardizing of options, prices was accomplished by a couple of gentlemen who actually won a Nobel prize in economics for coming up with a formula for pricing, for the pricing of options. And they actually determined, Hey, we need to figure out with stocks, different volatility levels, different times till expiration, different distances or different amounts of intrinsic value.
How do we come up with the pricing of those options? So we have two gentlemen named Fisher Black and Myron Scholes. They won that, uh, their Nobel prize in 1997, actually, sorry, Fisher Black, he actually died in 1995, didn't get a Nobel prize, but his partner, Myron Scholes did. But in any case, um, they came up with a formula that included these three elements. I don't think that this is hugely groundbreaking: stocks that are giving a bigger discount or contracts to give a bigger discount should be worth more; Contracts to have more time should be worth more; and Contracts on stocks that are more volatile should be worth more, but rates were also built in. Why do we care about interest rates when it comes to the pricing of options?
Well, if we're committing, in this case, we're committing 800 bucks to one contract here. That means we're tying up that money for a period of time. And what, uh, what Black and Scholes recognized is that there's an opportunity cost. There's a cost to committing one's money to one of those options. And that's what we're doing. And that's what we're doing. And that's what we're doing. And that's what we're doing. And that's what we're doing. And that's what we're doing. And there might have been opportunity elsewhere. And among those opportunities, they could say, well, you could go out and buy some highly speculative real estate and make some, hopefully make some money there. It's not very realistic, right?
Can't make huge assumptions about what a trader might've done with the money otherwise, if it weren't committed to an options contract, but are they missing out at least on the opportunity to go maybe give their money to the government for a short period of time and a T-bill get a little bit of income there? Yeah. Yeah. So options prices include an element for the possibility that we could be out there pursuing a little bit of income from interest that's being paid on government-issued securities in the short term. So, as rates, the bottom line there is as interest rates go up and down, and we've all been paying a lot of attention to what the Fed has been doing with interest rates over the last year or so, it's been a real topic of keen interest, that does influence options prices a little tiny bit.
This is included in the equation. I feel as an educator, I've got to talk about it, but I'll also say it's probably not going to be the part that most people are going to pay attention to. All right. But yeah, bottom line is if interest rates go up, options prices will nudge up as well. If interest rates are cut, which is possibly on the docket through the rest of the year, options prices will also typically be cut. And that applies to calls and to puts. In any case, yeah, the general pricing of these contracts comes from what's known as the Black-Scholes formula for options prices. But all of these things add up to the price that we are paying, how much intrinsic value we're getting, how much time on the contract, how much volatility, and where our current rates on the Fed funds rate, basically.
Yeah, Nobel Prize, Bruce, 1997, Nobel Prize for Economics. Yep. So that's how things are currently priced. Possibly more importantly to the trader is how might those prices change? So let me make some basic statements of fact about the changing of prices. Number one is if we buy this contract and the stock price goes up, that creates more intrinsic value on the contract and that can influence the price higher. Number two is if we buy this contract and nothing happens, but time goes by, that's chipping away at the value of the option, we experience something called time decay, and that reduces the value of the contract. Number three is if we buy this contract, and then all of a sudden traders think, hey, you know what?
We thought volatility for these next 72 days were going to be at a certain level, and now we think it's going to be higher. Maybe there's a new, I don't know, a lawsuit that that comes out against the company. Maybe there's a new contract they're about to sign for distribution of the product in a big new way, but the contract isn't signed yet. It could go either way. New volatility introductions. Volatility expectations can change, and the more volatility that's expected, that can influence the price up, or if volatility expectations shrink, it can influence prices down. AC100 says, what's today's topic? Understanding how options are priced, and how might they make or lose money? That's what we're talking about today.
All right, so those are the basic elements, but understanding how it's priced, while interesting, may not be as beneficial to the trader if they might also be able to anticipate how those prices might change, and do so very, very precisely. So I wanna talk about the Greeks now. Randy says, is there a way to quantify time and volatility? There certainly is. Yep, and it's by using the options Greeks. Yeah, so let's talk about the Greeks. We have our first Greek. I'm gonna be talking about five Greeks. This one, for some, might be the king of the Greeks, but however, I've also heard somebody say, hey Cameron, stock price did what I thought it was gonna do, and I didn't get the return on my option that I expected. And therefore, delta is broken.
Let me explain what I'm talking about here. But let's load up, first of all, here in our options chain, the Greeks. I'm gonna come up here to where the default is gonna be last price abbreviated to X and net change. So these are the columns that are being displayed at the moment. And instead, I'm gonna switch over here to our Greeks, delta, gamma, theta, and vega. Let's choose that. And so we're gonna be talking about delta, gamma, theta, and vega. And what each of these Greeks are doing is giving us insight into precisely how our option might change in value if price moves, if time goes by, if volatility rises or falls. And then there's another one that I wanna talk about here in a moment. I'll introduce that in just a moment.
But delta starts with D, so does dollar. So does dollar. Delta is our gauge, generally speaking, of how our option might change in value if the price of the option were to rise or fall a dollar. Now with each of our Greeks, there's a specific assumption. So let's look at our contract here. This 110 call that, oh, let's go back to the contract that we actually bought out here in April. Go down to 110, I'll put it up higher here so it'll be right over in line with our Greeks. We buy that 110 call. It's already changing in value. It's slipping in value. What's going on? Well, price, time, volatility, and rates-rates are changing, not right now. But in any case, price and time and volatility are in flux.
So our delta right now for our contract is 63. Now there are a couple of different potential implications for a delta. One of those implications, some traders will look at this as an approximate probability that a contract will still be in the money at expiration. So they might look at this and say, there's a 63% chance that our stock is still above 110 at expiration and the contract is still in the money. But there's another assumption here. This is it also tells us with a great not just a ballpark estimate this is precise This tells us if the stock were to go up a dollar the value of our contract assuming nothing else changed will change by 63 cents will increase by 63 cents So there's another assumption here An assumption that delta makes Delta assumes stock rises $1 okay And our current delta is 63 So let me rephrase that
If I buy this 110 call and I pay eight bucks for it and I ask myself the question okay so if the stock goes up a dollar how much do I make I make 63 cents Now that's assuming that our other variables don't change because the other variables definitely play a role. But that is an extremely precise number. It is the number that determines the future pricing of options, okay? So yeah. Now what if the stock price were to fall a dollar? Is that a possibility? Yep. And if it fell a dollar and it did it immediately, so no time has passed and volatility levels haven't changed, expected volatility levels for the next 72 days hasn't changed, the value of our contract would drop $0. 63.
And that's a big deal because look at this. This is an $113-ish dollar stock. If it were to go up a single dollar, the stock only went up less than 1%. But the contract increased by 63 cents, 63 cents on an $8.00. So that's a big deal. But the value of our investment is more like, what is that? About seven or 8% unrealized gain. That shows you how much leverage is in this contract. Seven or 8% up if the stock goes up a dollar, seven or 8% down if the stock goes down a dollar. But that's what Delta can tell us. And it's based on this as something that, the Greeks always assume a fixed thing. And with Delta, it's assumed that the stock price goes up.
So, if the stock price goes up, call owners make 63 cents, 62 or 63 cents. What happens with put owners? They lose money. Because a put is a bearish trade that loses money if the stock goes up. Bob says, can you distinguish the difference between Delta and probability? I can, it's not really what I wanted to get deeply into Bob, but as I discussed earlier, some people see this as an approximate probability that the contract will be in the money at expiration. That's another way that Delta might be used by traders, but another primary use, and the one that is very accurate, again, assuming that nothing else changes, is the either gain or loss on the contract if the stock rises or falls a dollar, just remember Delta starts with D, so does dollar.
So, there's our introduction to that Greek. That's an important one, but the rest are also important. What is gamma? Gamma is a smaller number here, still playing a role, but, yeah, Ted's saying approximate, with the probabilities it is approximate because we don't know the future, right? So, there's maybe a 63% chance it might work out, it might not. Right now, the probabilities are in its favor, but time will tell. It's not the way it works when price changes. When price changes, there is a direct impact on the contract price, okay? Alexis, I'm glad you liked that. So, let's talk about gamma. Gamma is, it might be the most complicated of the Greeks. So, if you latch onto this one in your first go, congratulations, I don't think it's really that difficult to pick up, but it's sometimes described as the rate of change to delta.
Eek, that sounds like a lot. But basically what's happening here is delta tells us how much the contract will make if the stock rises by a dollar. But what if it goes up another dollar? These Greeks are not static numbers. They actually change. You'll notice if we were to buy a different contract that's further in the money, it has a larger delta. If we were to buy one at a, let's say an out-of-the-money contract, it has a lower delta. So, Delta changes as the stock goes, as the price goes deeper in the money. Gamma just tells us how fast it changes. So, let me say it this way, if we, if this, and you'll notice our Delta has already changed, since I wrote it down. Yup, it changes.
But as of this moment, if we were to buy this call and the stock price immediately went up a dollar, that trader would be sitting on a 62 cent unrealized gain. If it then went up a second dollar, we would make another 62 cents plus three more cents. So in other words, that second dollar, we might make 65 cents. Now, what if the option, or what if the stock fell? First dollar, lose 62 cents. Second dollar, we actually don't lose 65 cents. We would subtract the gamma and lose 59 cents. So 62 minus three. Why is that? Well, it's because as the stock is going up, our contract is growing in size and we can make more money on it. If the stock is falling, the contract is losing value.
And there's just, there's getting to be less and less value left there to lose. So gamma has a shrinking effect on Delta as price goes down. It has a compounding effect as stock price goes up. Ted says, can gamma also be affected by volatility? Ted, they all work together. So it's hard to separate one from the other, but I can say they each play their individual little roles. Yeah. So our current gamma, also assumes stock price rises one dollar and just helps us anticipate what might that next dollar make. Okay. What was it? It was three cents. Yeah. Yeah. This is, don't be worried. Don't worry that Delta has changed. It's just a reflection of the fact that the Greeks are not fixed. They're not static in time. They change. Okay.
Theta. Theta starts with T. So does delta. Theta is time. This is our gauge of how fast time is chipping away at our contract. If we buy these contracts right now, they have 72 days on them. We lock in a purchase price for 110 days. And now we're hoping, okay, stock should go up. Hopefully it'll go up, right? Let's say we come back tomorrow. Stock hasn't budged. Price hasn't changed. We now realize we don't have as many days of potential in this contract anymore. It's a little bit less. And you'll notice the theta, theta is a negative number. Theta assumes one day passes. And the outcome here is the loss of 5 cents.
So if you've ever wondered, if I buy this call, thinking the stock is going to go up and it doesn't, how much is that call going to be worth tomorrow? It's going to be worth 5 cents less. Instead of being worth $8, it'd be worth $7. 95. That's what we're looking for. That's an important thing to know. Now we know how much of an uphill battle we have. Now we can know what sorts of steps can a trader take to try to mitigate that? Well, you'll notice here, maybe they could go deeper in the money that reduces the impact of time compared to how much is spent on the contract. Or we could just buy more time.
If we go further out in time, that theta number is going to be smaller compared to the amount of money that we've invested in that call contract. But there we go. There's the impact of time. And now we also have V. V, vega? Yeah, it starts with V. So does volatility. This is our contract's sensitivity to changing levels of expected volatility in the future. So right now, well, vega assumes a 1%. Let's, it assumes volatility. Let me spell that correctly. And I'm going to abbreviate it to vol. We know it's volatility. It's not volume, it's vol, okay? Volatility. It assumes volatility rises 1%. If it does, if volatility were to rise, would that help or harm this trade? It would help it. That's a positive number.
So that would be, we have a delta right now of 19 cents. Or to say this a different way, let's say that we buy this contract right now for eight bucks. Let's say that we buy this contract right now for eight bucks. I know prices have changed since we started talking, but we buy the contract for eight bucks and then traders get wind that there's something new on the horizon that could introduce a higher level of volatility in the next 72 days. And let's say that expectation of volatility goes up 1%. The stock is expected to be 1% more volatile over the next 72 days. That would increase the price of these options by 19 cents. And you'll notice it will increase the price of the calls.
It also increases the price of puts. But volatility has a direct impact on the pricing of options. So now let's do a little thought experiment. See if we're following along. Let's say we bought the contract for eight bucks. The stock goes up a dollar over the next one day while volatility drops 1%. What would be the value of our contract tomorrow? Well, bought it for eight bucks. Stock went up a dollar. We make 63 cents. That would be $8. 63. But time decay chipped away five cents. So that would be $8. 58 rising. Did I say volatility dropped? Yeah, I did say volatility dropped. So $8. 58 minus 19 cents would take us down to what? Eight, boy, somebody's going to have to correct my math. $8.
39, I think that's right. Yeah, yup. So knowing the Greeks can help the trader understand how price, time, and volatility are likely to drive the pricing of their options. Now, as we get further into our discussion of trading options, we're going to talk about how might a trader try to anticipate which direction price is headed? How might a trader anticipate which direction volatility is likely headed? Um. I don't have to tell you anything about time. Time passes. I don't have to look at a chart for that. So those are the big three. And what's happened before is somebody will say, 'Hey, Cameron, I bought my call.' Let's say I bought the call for eight bucks. The stock went up a dollar and I lost money. That doesn't make any sense.
Your delta is broken. No, it's delta is not broken. It's just that we're missing out on part of the equation here. Options are not priced incorrectly. They're priced very consistently using a consistent, consistent algorithm, regardless of market, market scenarios. Options prices are the prices. They're not wrong. So what might that trader be missing? Well, maybe their stock made a $1 move up, which is great for calls, but it took 20 days to do it. And time was killing the value of that, that trade chipping away at that return and volatility level, the volatility expectation, right? So we lost when our options dropped. Yup. That can definitely have an impact. And as a matter of fact, how might we gauge that impact over a longer period? Let me throw out a different scenario.
Agariba says, what's the difference again between the 30 . 6% and the Vega of 19? What are you looking at as a 30 . 6? I don't know what you're talking about. Unfortunately, Agariba, I don't have a 30 . 6 on my screen. I think maybe it's a 30. 6. You're talking about oh up here yeah so that's that's showing under this Vega column but it's not a Vega value this is so 30. 61 is not Vega, it's actually known as the Market Maker. Move it's a different expectation this is a plus or minus range how much that how much traders are expecting the stock to move over the next 72 days, different okay I know that it's showing up underneath Vega but that's just because that's where the Vega column is if I move that column it wouldn't it wouldn't be about you know I could put something else here and it would look like the 30.
59 is referring to that it's not okay anyway but what i just threw out earlier was this simple ish scenario what if the stock went up a dollar in one day while volatility dropped one percent well the greeks can help us with that where the greeks really start to stumble is when we get beyond the first dollar we get beyond the first day we get beyond that first volatility that first day we get beyond that first day we get beyond that first day we get beyond that first one percent change in volatility what if the trader saw this and they thought oh i think the stock is likely to go up maybe maybe their expectation is going to go up twenty dollars
but it's going to take 15 days to do it and maybe volatility volatility changes a couple of percent whatever wouldn't it be nice if we just had a calculator that plugged in all these values and spit out a future expected value of the of the option yep we have something called just that um it's called a theoretical price calculator before we go to that though I want to show you one more Greek little old row and this row starts with R, it has to do with interest rates, remember interest rates play a role they play a tiny little role in most circumstances but row assumes rates rise one percent now rates in in recent years have actually been going down, right? But let's look at this. Let's add row.
Let's go to Delta, Gamma, Theta, Vega. Let's customize this and add row to the equation. So here's row and it has a value of 12 cents. So if we assume interest rates went up 1%, that would have the effect of increasing the value of our call contract by 12 cents. All right, woohoo. Sitting on an unrealized gain of 12 cents. Well, how likely is it that the interest rates are actually gonna go up 1% by the 17th of April? Not likely at all. As a matter of fact, if you check the CME's FedWatch tool, there is about a 15 to 13% probability that rates might go down by a quarter of a percent by April. Quarter of a percent would mean instead of fluctuating 12 cents, maybe we've gone down 3 cents.
Is that something to think about? Maybe. But in this case, we have a 12 cent row. This is usually not something that most traders pay a lot of attention to. But in any case, there is a calculator right here. It's called Theo Price. If I load up Theo Price, it loads up this field right here. If I click on that, it allows me to make, to input expectations for changes in these values. What if I bought this call, notice here's our Theo Price column, and our call keeps losing, let's see. It's a 110, yeah. Let me hit reset, cause I've already tinkered with this a little bit. There we go. Reset right now, call's worth about eight bucks. Well, I wonder how much it would be worth next week, assuming prices didn't change.
Oh, now it's only worth seven and a half dollars, time decay. Yeah, but what if price went up $10 in the meantime? Oh, now it's worth 15 bucks. So time decay and price changes included. And finally, what if our volatility were to drop a few percent? That's gonna reduce that future expected value. So this is a nifty little tool that can help a trader maybe gauge future values in their options. But with that little tool, notice I left the calculator for the end because I don't like to lead with the thing that's sort of a shortcut or a crutch. But guys, we have discussed; we've acquainted ourselves with how options are priced and how options can change just based on price, time, volatility, and yes interest rates.
So we've accomplished what I set out to do today. That prepares us for our next discussion, which is going to be building combination strategies, use them to build a future. The building blocks that we learned in lessons one through four. We're going to do long call spreads next week. Talk about those. How much can they make? How much do they lose? What attracts the traders to those? All of those sorts of things. So I hope you'll join me in lesson six. Time for me to let you go. But as I do, just remember, if you haven't subscribed to the channel yet, make sure that you're subscribed to our Trader Talks channel on YouTube. Go down, click on that subscribe button. This is where we host the playlists of previous webcasts.
And this is where you can also join our live streams. Make sure that you're also following Connie and me on X. You can follow Connie at ConnieHillCS. You can follow me there at CameronMayCS. But that is the best place to connect with your favorite presenters in between the live streams. And neither one of these actions costs anything. I also want to thank everybody who's already given the thumbs up out there. Click the like button. Looks like with the 200 people watching, already 63 people have already clicked the like button. Thank you for doing that. That sounds like applause to me. It also gives my webcast a little boost in the YouTube algorithm so that the archive can find a wider audience and help more people understand how options are priced. Final plea is to, yeah, please give me feedback in that survey. Connie's reposted that a couple of times. Thank you, Connie. But everybody, I'll let you go. Go enjoy the rest of our webcast for the rest of the day. I'll look for you in lesson six. I'll also look for you on X. But whenever I see you again, until that moment arrives, I want to wish you the very best of luck. Happy trading. Bye-bye.
