How To Determine Options Liquidity?

Quite often I read articles which tell us that options liquidity can be measured by open interest. Because when options have high open interest, this means there are more people interested in the trade, and as a result, it’s more likely for us to get a better pricing for the trade.

Yes, this is quite true. Normally, the higher the open interest, the more likely we’ll be to trade that option at a narrower spread between bid & ask prices. On the other hand, the lower the open interest, usually there will be a wide spread between bid & ask prices.

However, in many occasions, I found that options with high open interest still have a wide bid-ask spread, i.e. about $0.3 or more.
On the other hand, sometimes options with low open interest might have a narrow bid-ask spread too. When I traded such options, the fillings were also quite fast.
Therefore, to me, open interest is not really the important criteria to decide whether I should trade the option or not. It’s the spread between bid & ask prices that matters more to me.

Generally, the maximum bid & ask spread I’m willing to accept is $0.20 for ITM options, $0.15 for ATM, and $0.10 for OTM options.
So, although the open interest is high, but if the bid-ask spread is too high, I’ll normally pass that trade. On the contrary, even though the open interest is low, but the bid-ask spread is still acceptable, I may still trade that options.
But of course, ideally I like to trade options with high open interest and narrow bid-ask spread.

Why getting a narrow spread between bid & ask prices is important?
Because this can affect your profitability significantly. Also, it’s important to consider how much the stock price is expected to move versus the bid-ask price spread of the options.

For instance:
You expect a stock to increase by $1 within a very short term. If you buy an ATM Call option (delta is 0.5) and the bid-ask spread is $0.4. That means, just to break even, the stock price will need to increase approximately by $0.80 (=$0.4 / 0.5). Should the stock price moves as expected and rises by $1, you’ll only profit about $0.1 [=($1 x 0.5) – 0.4]. If the stock only increases, say, by $0.6, you will still lose money.

On the other hand, if the bid-ask spread is only $0.1, you only need the stock price to move up by about $0.20 (=$0.1 / 0.5) before you can start to profit. If the stock price does rise by $1, you would gain about $0.4 [=($1 x 0.5) – 0.1].

Related Posts:
* A Chance to Learn from World Class Trading Experts For FREE You Should Not Miss
* Option Chain
* Difference Between Option’s Volume and Open Interest

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Difference Between Option’s Volume and Open Interest

In stock trading, you measure stock market activity & liquidity by volume. In options trading, there are two measurements: Open Interest & Volume.

Unlike in stock trading, whereby there is a fixed number of shares to be traded (i.e. number of outstanding shares), in options trading, new option contracts need to be created when a trade is placed and there is no existing contract yet. When a new expiration month initiated, there is no open interest because there are no option contracts being traded for that month yet. As trading builds up, open interest will also increase. Now, what is Open Interest?

Open interest is the total number of option contracts that are still open (i.e. have not yet been exercised, or have not been closed out by an offsetting transaction, or have not expired).

Open interest increases when new contracts are created by options buyer and seller, whereby a new buyer takes a new long position and a new seller takes a new short position.

On the other hand, open interest decreases when both the options buyer and seller with existing position close out their respective positions and the contract disappears.
Closing out the position can be done by doing an offsetting transaction (i.e. the existing buyer sells the option to close his long position while the option seller buys back the option to close his short position), or by exercising the option.

Please bear in mind that open interest only increases when new contracts are created. Hence, when a trader who does not have a position in the option before buys from another trader who has an existing long position and want to close his position by selling his option contract, open interest does not change because a new contract is not created.

Then, what is volume in option trading and how option’s volume is different from open interest?

Option’s Volume is the number of option contracts traded during a given period of time. Hence, volume reflects the number of options contracts that changed hands from a seller to a buyer, regardless of whether it is a new contract being created or just an existing contract.

For more clarity, let’s see the examples below:

On Day 0, Open interest = 0, Option Volume = 0.

On Day 1, A buys 2 option contracts and B sells 2 option contract.
Open interest = 2, Option Volume (for that day) = 2.

On Day 2, C buys 7 option contracts and D sells 7 option contracts.
Open interest = 2 + 7 = 9, Option Volume (for that day) = 7.

On Day 3, A closes out his position by selling 2 option contracts, and D closes out part of his position too by buying back 2 of his option contract.
Open interest = 9 - 2 = 7, Option Volume (for that day) = 2.
Open interest reduced by 2, because A & D have an existing position before, so this transaction is an offsetting transaction to close out their respective positions. As a result, 2 contracts disappear.

On Day 4, E buys 3 option contracts from C who wants to sell part of his option contracts (3 contracts).
Open interest = 7 (no change), Option Volume (for that day) = 3.
When E buys from C, it does not create new contracts. E who does not have a position in that option before simply replaces C who wants to exit his long position. Hence, open interest does not change.

Related Posts:
* Option Chain
* How To Determine Options Liquidity?
* FREE Trading Educational Resources You Should Not Miss
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks

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More Understanding about Options Time Value

As we know, an option’s price comprises of 2 components: Intrinsic Value + Time Value.
Assuming all other things remain constant (i.e. no changes in the underlying stock price and volatility), the time-value component of an option is affected by 2 variables (both for Call & Put Options):

* Time remaining until expiration.
The longer the time to expiration, the more time value the option will have.

* The closeness of the option Strike Price to the money.
At-The-Money (ATM) options have the maximum level of time value, and the time value decreases as it moves to deeper In-The-Money Options (ITM) and deeper Out-Of-The-Money (OTM) options (like inverted-U curve).
Time value is at its highest level when an option is ATM because the potential for Intrinsic Value to begin to increase is the greatest at this point.

Note:
ATM options have the highest level of time value. Time value decreases as it moves to deeper ITM or OTM options (like inverted-U curve).
This can be understood better if we see the time value as the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish ITM.
The more uncertain, the higher the time value will be.
An option that is far OTM has almost no chance of finishing ITM. As such, it will not command a high time value.
An option that is already deep ITM is almost certain that it will finish ITM, hence time value is smaller.
But ATM or near ATM options have more uncertainty as to whether or not the options will finish ITM, and therefore these options have a higher time value.



In addition, we know that for both Calls & Puts, the time value component of an option price decreases as expiration is nearing, and the decrease rate is accelerating as it is getting closer to expiration, particularly for At-The-Money (ATM) options. This means that the amount of time value disappearing from the option price per day gets bigger with each passing day.

Please note here that Time Value decrease at an accelerating rate as expiration nears is true only for ATM option. This is because for ATM option, Theta increases as an option get closer to expiration (Please refer back to the previous post here).
For ATM option, time value decreases sharply particularly the last 30 days before expiration.

Nevertheless, for both ITM & OTM options, Theta decreases as an option is approaching expiration. Hence, for both ITM & OTM options, Time Value actually decreases at a decelerating rate as expiration nears.

Sigma Options had a good article about this in “What You Didn’t Know About Time Decay”.

Related Articles:
* In-The-Money, At-The-Money, and Out-Of-The-Money Options
* Option Price Components
* Options Pricing: How Is Option Priced?
* Option Greeks

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OPTION PRICING: How Is Option Priced? (Part 2)

In Part 1, we know that there are 6 factors that affect option's price: option’s strike price, stock price, time to expiration, implied volatility, interest rate, and dividend.

Nevertheless, the impact of interest rate and dividend are often considered negligible as compared to the other factors. Most of the time, for each level of strike price, an option’s price will move due to the movement of underlying stock price, volatility and time.

The Black-Scholes formula can be used to calculate the theoretical value of an option based on the above factors.

What is the use of knowing an option’s theoretical value? By knowing the option’s theoretical value, option traders can compare the prevailing option price in the exchange against this theoretical value to determine if a particular option contract is over or under valued, hence helping them in their option trading decision.

Options Calculator / Pricer is normally used to help compute the theoretical value of option price.

THE IMPACTS ON OPTION’S POSITION

Since option’s buyers (long position) will profit when the option price rises after they buy (Buy Low, Sell High), whereas the seller (short position) will profit when the option price falls after they sell (Sell High, Buy Low), the impact of the above factors will also be different.

The following table shows how the major factors (stock price, time to expiration, implied volatility) affect an option’s position.

Example:

Increase in Implied Volatility (IV) would increase option’s price (both calls & puts), assuming other factors unchanged. Hence, this will be favorable for option buyers who will gain if the option price increases (buy low, sell high), but unfavorable for option sellers that will profit if the option price drops (sell high, buy low).

Related Topics:
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks
* FREE Trading Educational Videos You Should Not Miss

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OPTION PRICING: How Is Option Priced? (Part 1)

Option price does not always move in conjunction with the price of the underlying stock. As such, it is important to understand what factors contribute to the movement in the option price, and what effect they have.
There are 6 factors that affect option price:

1. OPTION STRIKE PRICE
Strike price determines whether an option is In-The-Money, At-The-Money, and Out-Of-The-Money.
The more deeply In-The-Money (ITM), the higher the option price will be, as it carries more intrinsic value.
The further an options is Out-Of-The-Money (OTM), the lower the option price will be.

2. CURRENT STOCK PRICE
This factor has opposite impact on call and put (assuming all other factors kept constant):
When stock price increase, Call premium will increase and Put premium would decrease.
When stock price decrease, Call premium will decrease and Put premium would increase.

3. TIME (NUMBER OF DAYS) REMAINING UNTIL EXPIRATION
This factor affects the Time Value component of an option price. All other things being equal, an option with more days to expiration will have more Time Value component than an option with fewer days to expiration.
In general, for both Calls & Puts, the Time Value component of an option price decreases or “erodes” as expiration is nearing (often called “Time Decay”). And the Time Value component would decrease at an accelerating rate as it is getting closer to expiration, particularly for At-The-Money (ATM) option.
Due to time decay effect, even though a stock price, say, just remains constant till expiration, an Out-Of-The-Money (OTM) option price which contains only time value will decrease over time and then expire worthless. Therefore, time is the enemy of options buyers, but a friend for options sellers.

4. IMPLIED VOLATILITY (IV)
Volatility is a measure of risk / uncertainty of the underlying stock price of an option. It reflects the tendency of the underlying stock price of an option to fluctuate either up or down. Volatility can only suggest the magnitude to the fluctuation, not the direction of the movement of the price.
Implied Volatility (IV) here is an estimate of future volatility. Since it is only an estimate, it is the most subjective and probably the most difficult factor to quantify. Nevertheless, IV can have a significant impact on the time value component of an option's premium.
Higher Implied Volatility reflects a greater expected fluctuation (in either direction) of the underlying stock price, and as such it is more likely that the underlying stock will move in your favor.
As a result, the higher the Implied Volatility of the underlying stock, the more expensive its options (both Calls & Puts) will be, because there is a greater possibility that the options will end up in your favor profitably.

5. INTEREST RATE
The impact of interest rate on option’s price has something to do with the “carrying cost” of stocks. When you are bullish on a certain stock, it is much cheaper to buy Call option than the stock itself. The interest cost should you buy the stocks is built into the Call option’s value.
In this case, all other things kept constant, an increase in interest rates will lead to an increase in Call premiums and a decrease in Put premiums.
However, in reality, all other things rarely remain constant. An increase in interest rates will generally result in a drop in stock prices, and this impact would often overwhelm the effect of interest rate on option price. Therefore, the impact of interest rate on option’s price is not certain, depending on the combined effects of the change in stock price (due to interest rate changes) and the “carrying cost” effect.

6. DIVIDEND
A stock price is expected to drop by the amount of the dividend on the ex-dividend date. Hence, high cash dividends imply lower call premiums and higher put premiums.

Continue to Part 2

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Option Chain

Option Chain is a list of option prices of a particular underlying stock for various strike prices, expiration dates, and option types (calls or puts). This is where option traders get the current market price of an option during trading hours. The prices in the Option Chain will change throughout the trading day based on the stock price movement, volatility and time.

A sample of option chain can be seen below.

Picture courtesy of Optionsxpress.

THE COMPONENTS OF OPTION CHAIN:

• Option Expiration Month: The months on top of the table.


• Strike Price: The prices at the center (vertical).


• Calls are at the left of the Strike Price, and Puts are at the right of the Strike Price.


• Ask Price: The price when you buy an option (i.e. the price where the market makers are willing to sell).


• Bid Price: The price when you sell an option (i.e. the price where the market makers are willing to buy).


• Last Price: The last traded price.


• Volume: The number of contracts traded for that particular option during the trading day.


• Open Interest: The total number of option contracts that are still open for that particular option.


• Symbol: A unique symbol assigned to that particular option of a certain underlying stock with certain strike price & expiration month.

A FEW THINGS TO HIGHLIGHT:

• You can determine whether a certain option is In-The-Money (ITM) or Out-Of-The-Money (OTM) by comparing it with the current market price. In this example, the current market price is available just below the word “Strike Price”.


• Some Option Chain may differentiate between ITM or OTM options by using different color. In this example, ITM options are shaded in yellow, while OTM options are in white.


• For Call options, ITM options (shaded in yellow) are at the upper left side of the table. As you can see, the lower the Strike Price (the more ITM the call options), the more expensive the call option price will be. On the other hand, OTM options (in white) are at the lower left side of the table. The higher the Strike Price (the more OTM the call options), the cheaper the call option price will be.


• For Put options, ITM options (shaded in yellow) are at the lower right side of the table. As you can see, the higher the Strike Price (the further ITM the put options), the more expensive the put option price will be. On the other hand, OTM options (in white) are at the upper right side of the table. The lower the Strike Price (the further OTM the put options), the cheaper the put option price will be.

EXAMPLES:

The picture above is the Option Chain for DELL with Expiration Month of Jun 07.
In this example, the last price of DELL is $26.02. This price is in between Strike Price 25 and 27.5.

Therefore, for Calls (at the left of the Strike Price column), the Strike Prices from 25 or lower are ITM options, while the Strike Prices from 27.5 or higher are OTM options.

And for Puts (at the right of the Strike Price column), the Strike Prices from 25 or lower are OTM options, while the Strike Prices from 27.5 or higher are ITM options.

Suppose you want to buy 2 contracts of DELL Jun 25 Call, the option price will be $1.7 (Ask Price), hence you need to pay: $340 (= $1.7 x 2 contract x 100 shares/contract).

Suppose you want to sell 2 contracts of DELL Jun 25 Call, the option price will be $1.6 (Bid Price), as such you will receive: $320 (= $1.6 x 2 contract x 100 shares/contract).

As you can see, if you buy an option and sell it immediately, you will lose $0.1 (=1.7 – 1.6) due to the Bid-Ask Price Spread.

Related Posts:
* Difference Between Option’s Volume and Open Interest
* How To Determine Options Liquidity?
* Options Pricing: How Is Option Priced?

* Options Trading Basic – Part 2

* FREE Trading Educational Resources You Should Not Miss

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Option Price Components (Part 2)

Go back to “Part 1”

EXAMPLES FOR INTRINSIC VALUE & TIME VALUE CALCULATION:

For Call Option:
Current stock price = $30.
The price of Call option with Strike Price of $20 = $12
This call option is In-The-Money (ITM) option because Strike Price ($20) < Stock Price ($30).
Intrinsic Value = Stock Price – Strike Price = $30 – $20 = $10.
Time value = Option price – Intrinsic Value (if any) = $12 - $10 = $2
Here, the call option is said to be In-The-Money with intrinsic value of $10, as it allows the call option buyer to immediately buy a $30 stock at $20 the moment he bought it.

Current stock price = $30.
The price of Call option with Strike Price of $40 = $0.5
This call option is Out-Of-The-Money (OTM) option because Strike Price ($40) > Stock Price ($30).
Intrinsic Value = 0 (No intrinsic value for OTM option)
Time value = Option price – Intrinsic Value (if any) = $0.5
Here, the call option is called Out-Of-The-Money, as it is better for the call option buyer to buy the stock from the market at $30 than to immediately exercise the option at $40 strike price.


For Put Option:
Current stock price = $30.
The price of Put option with Strike Price of $35 = $6.
This put option is In-The-Money (ITM) option because Strike Price ($35) > Stock Price ($30).
Intrinsic Value = Strike Price – Stock Price = $35 – $30 = $5.
Time value = Option price – Intrinsic Value = $6 - $5 = $1.
Here, the put option is said to be In-The-Money with intrinsic value of $5, as it allows the put option buyer to immediately sell a $30 stock at $35 the moment he bought it.

Current stock price = $30.
The price of Put option with Strike Price of $25 = $0.3.
This put option is Out-Of-The-Money (OTM) option because Strike Price ($25) < Stock Price ($30).
Intrinsic Value = 0 (No intrinsic value for OTM option).
Time value = Option price – Intrinsic Value (if any) = $0.3.
Here, the put option is called Out-Of-The-Money, as it is better for the put option buyer to sell the stock in the market at $30 than to immediately exercise the option at $25 strike price.

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Option Price Components (Part 1)

The price of an option consists of 2 main components:
Intrinsic Value and Time Value (Time value is also known as Extrinsic Value).

OPTION PRICE = INTRINSIC VALUE + TIME VALUE

Intrinsic Value is the value that is already built into the option the moment you bought it. Or in other words, the value by which an option is "in-the-money".
Time Value is the difference between an option’s price and its intrinsic value. As the option nears expiration, the time value erodes and eventually becomes zero.

Only In-the-Money (ITM) option has intrinsic value.
For At-The-Money (ATM) and Out-Of-The-Money (OTM) options, the intrinsic value is zero, therefore the option price comprises of only time value. Therefore:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

HOW TO CALCULATE INTRINSIC VALUE & TIME VALUE:

Intrinsic Value of ITM Call Option:
Intrinsic Value = Current Stock Price – Strike Price.

Intrinsic Value of ITM Put Option:
Intrinsic Value = Strike Price – Current Stock Price.

Time Value of All Options (ITM, ATM, OTM):
Time value = Option price – Intrinsic Value (if any)

As a result, the deeper we move into the money, the higher the option price will be (as it has more intrinsic value). The further we go out of the money, the cheaper the option price would be.
The option prices will change throughout the trading day based on the underlying stock movement, volatility and time.

Continue to “Part 2”

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In-The-Money, At-The-Money, and Out-Of-The-Money Options (Options Moneyness)

Options Moneyness
Options Moneyness is the relationship between an option’s Strike Price with the current price of the underlying security (i.e. stock price).

There are 3 states of Options Moneyness:
* In The Money (ITM)
* At The Money (ATM)
* Out Of The Money (OTM)
As the stock price moves, an option would move from one moneyness state to another.

Whether an option is In The Money (ITM), At The Money (ATM), and Out of The Money (OTM) is determined by the relationship between an option’s Strike Price with stock price (i.e. where the Option’s Strike Price is in relation to the current stock price).
This relationship is also depending on the types of options, i.e. whether it is Call or Put option.

For Call Option:
Call options is called “In The Money (ITM)” if the Strike Price is less than the current stock price, because the call option buyer has the right to buy the stock at the price that is less than the price he would have to pay if he buys the stock in the market.
Call options is called “At The Money (ATM)” if the Strike Price is equal to the current stock price.
And Call options is called “Out Of The Money (OTM)” if the Strike Price is more than the current stock price, because it will be cheaper to buy the stock from the market than to exercise the call option.

For Put Option:
Put options is called “In The Money (ITM)” if the Strike Price is more than the current stock price, because the put option buyer has the right to sell the stock at the price that is more than the price he would receive if he sells the stock in the market.
Put options is called “At The Money (ATM)” if the Strike Price is equal to the current stock price.
And Put options is called “Out Of The Money (OTM)” if the Strike Price is less than the current stock price, because it will be better off to sell the stock in the market than to exercise the put option.

Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks

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Options Pricing

Options Pricing:
* In-The-Money, At-The-Money, and Out-Of-The-Money Options (Options Moneyness)
* Option Price Components
* Option Chain
* Option Pricing: How Is Option Priced?

Options Volume, Open Interest & Bid-Ask Price Spread:
* Difference Between Option’s Volume and Open Interest
* How To Determine Options Liquidity?


Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic – Part 1
* Understanding Implied Volatility (IV)
* Understanding Option’s Time Value
* Option Greeks
* Learning Candlestick Charts
* Learning Charts Patterns

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Potential Risk & Rewards of Options Buyer vs. Seller

Potential Risk & Rewards of Options Buyer
The maximum loss of a buyer of an option is the initial premium he pays for the contract, regardless of what happens to the stock. So, the risk to the buyer is limited, never more than the amount spent to buy the options, but the potential profit is theoretically unlimited.

Potential Risk & Rewards of Options Seller
On the contrary, in return for the premium received from the buyer, a seller of an option would need to take on the risk of having to sell (for calls) or buy (for puts) the stocks should the buyer decides to exercise his right. If that option is not covered by another option or a position in the underlying stock, the seller's loss can potentially be unlimited. Writing options without covered by another options (e.g. spreads) or a position in the underlying stock (e.g. covered call/put) is called writing Naked (Uncovered) Options. Since writing naked options has only a limited profit (i.e. the premium received) but is exposed to unlimited potential risk, it is not an advisable thing to do, especially for beginners.











For beginners, it’s much simpler just to buy calls if you expect a stock will increase or puts if you expect a decrease, which offers limited risk and unlimited potential profit. Only after you get more trading experiences and completely familiar with how options work, you may then choose to move on to learning more complex option strategies, which allow you to be a seller without getting exposed to unlimited risk.

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When Should You Buy / Sell Call or Put Option?

As we know, buyers would profit if they buy a security at lower price and sell it at a higher price (Buy Low, Sell High), while Sellers would profit if they sell a security at higher price and then buy it back to close their position at a lower price (Sell High, Buy Low).

Since Call option price goes up when the underlying stock’s price goes up, and vice versa, we would buy a Call Option if we are bullish and expect a stock will increase before option expires.
On the other hand, we will sell or "write" a Call Option if we are bearish and anticipate a drop in the underlying stock’s price before the option’s expiration date, or if we expect the stock price to move sideways.

As for Put options, since Put option price increases when the underlying stock’s price decreases, and vice versa, we will buy a Put Option if we are bearish and foresee a stock will move downwards before option expiration. Conversely, we will sell or “write” a Put Option if we are bullish and expect a stock will move up before option expires, or if we think the stock price will go nowhere.

However, before you decide if you should be a buyer or seller, it is extremely crucial to understand potential risk & rewards for options buyer vs. seller.

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Options Buyer vs Seller

There are 4 participants in the options markets:
1. Buyers of Call options
2. Sellers of Call options
3. Buyers of Put options
4. Sellers of Put options

People who buy options are called “buyers” or “holders”, and those who sell options are called “sellers” or “writers”. Buyers are said to have “long” positions, and Sellers are said to have “short” positions.

Buyers open a position in the market by buying a security and close a position by selling the security. Whereas Sellers open a position by selling a security and close a position by buying back the security.

When the buyer of the option contract uses the right to buy or sell the security, it is called to “exercise” the option.

On the contrary, when the seller of the option contract is obligated to sell or buy the security when the buyer chooses to exercise the option, it is said that the sellers has got “assigned”. Once he is assigned, he must fulfill his obligation to sell or buy the security as per contract. To avoid assignment, sellers need to close their position by buying back the options.

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What is Put Option?

Put option is a contract that gives the buyer of the options the right to sell the underlying security at a particular price (i.e. strike price) on or before a certain date (i.e. expiration date).
The seller (or writer) is, in turn, obligated to buy the security should the buyer chooses to exercise the option.

Put option’s price increases when the underlying stock’s price decreases, and decreases as the underlying stock’s price increases (negative relationship).
As such, we will buy a Put Option if we think that a stock will move downwards.

Example:
Using the above Company ABC example, if you anticipate the stock to drop from $23 per share, you can buy a Put option for $90 (or $0.9 per share) that gives you the right to sell 100 shares of ABC at $22.5 per share anytime in the next 90 days.

If the stock falls to $20 per share before option’s expiration:
1) You can, in theory, buy 100 shares in the open market for $20 per share and then exercise your put option which gives you the right to sell the stock at $22.5 per share. Your profit will be $1.6 per share (22.5 – 20 = 2.5 – 0.9 for option premium = $1.6 per share).

2) In practice, you would just sell your put option, which would now have a value of at least $2.5 per share (intrinsic value only) and profit by $1.6 per share (2.5 – 0.9 for option premium = $1.6 per share).

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What is Call Option? (Part 2)

Click here to go back to “What is Call Option? (Part 1)”

Example:
Company ABC is currently trading at $23 per share. You believe the stock will be going up within a short time period. Hence you buy one contract of Call option that gives you the right, but not the obligation, to buy 100 shares of the company anytime in the next 90 days for $25 per share. The option’s price is $0.5, so you will buy one option contract for $50 (multiplied by 100 shares per contract).

If your prediction is right and the stock rises to $ 28 per share before the option expires, there are 2 alternatives you can do:
1) You could exercise your option and buy 100 shares at $25 per share and sell them for an immediate profit of $2.5 per share ($28 - $25 = $3 - $0.5 for the option premium = $2.5 per share). However, as a practical matter, options traders rarely choose this alternative.

2) You could simply sell the option contract for a profit without actually buying the shares of stock. When the stock price increases to $28, the option price would at least be worth of $3.00 (intrinsic value only). Hence, you will also gain $2.5 per share ($3 - $0.5 for the option premium = $2.5 per share). This is what options traders will normally do.

On the other hand, if your prediction is wrong and the stock moves nowhere or drops from the original $23 to $21 per share, you would simply let the option expire worthless and suffer only a $50 loss (the option price), because in this case, most likely the option would have no value.

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What is Call Option? (Part 1)

Call option is a contract gives the buyer of the options the right to buy the underlying security at a particular price (i.e. strike price) on or before a certain date (i.e. expiration date).
The seller (or writer) is, in turn, obligated to sell the security should the buyer decides to exercise the option.

Call option’s price increases when the underlying stock’s price increases, and decreases as the underlying stock’s price decreases (positive relationship).
Hence, typically we will buy a Call Option if we expect a stock will go up before option expires.

Click here to continue to "What is Call Option? (Part 2)"

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Stock Option Contract Specification

An option contract specifies the following:

• The underlying stock (e.g. AAPL, DELL, MSFT, etc.)
• The Expiration Date of the contract (i.e. Third Friday of the Expiration Month)
• The Strike Price (or Exercise Price)
• Option Type: Call or Put option
• The Price of the option contract, which is often called “Premium”
• Number of option contracts

By default, one option contract represents 100 shares in the underlying stock, whereas the quoted price of an option is per share. Hence, the quoted price of an option must be multiplied by 100 to get the cost of option per contract.

The common format to specify stock option contract is as follow:

The underlying stock ticker, Expiration Month, Strike Price, Call / Put

Example:
AAPL May 95 Call refers to Call option for Company AAPL (Apple Inc.) with Strike Price of $95 and Expiration Date of the third Friday of May.
Suppose you buy 2 AAPL May 95 Call with option price of $5, the total cost will be: 2 contracts x 100 shares/contract x $5 = $1,000.

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Stock Trading vs Options Trading

Option trading is much more complex and risky as compared to stock trading.
When investing in stocks, you only have to worry about one thing, which is price; whereas in options trading, there are additional variables that influence an option's price.

In order to be profitable in stock, you need to be right in the expected direction of underlying stock price movement. In options, on top of that, you also have to be right in the expected magnitude of the movement as well as the time needed for the movement to happen. As a buyer of an option, you will want the expected movement to occur quite soon so that the time value lost will be minimal, and the magnitude of movement is big enough to cover the loss in time value while waiting the stock to move. If either of these two is wrong, you might still lose money although the direction is correct.

Additionally, due to the leverage effect, if you are wrong, if you could have higher % loss from options trading than from stock trading, given the same move in the underlying stock price. Although in terms actual dollar, the loss from options trading should be smaller than it does from stock trading, provided the number of shares are the same.

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Why Option Trading? (Part 2)

Click here to go back to “Why Option Trading? (Part 1)”

3. Leverage

You can potentially have greater % return of investment from options trading than from stock trading, given the same move in the underlying stock price.

For example:
A stock price of Company ABC (currently trading at $96) is expected to increase significantly over the next few weeks. The Call option price for that stock with Strike Price of $95 and 45 days to expiration is $6.
If you buy 100 shares of that stock, you need to invest $9,600 to purchase the stock. Assuming the stock price increases to $105 within 15 days, you would gain $ 900 (= 10,500–9,600) or 9% (= 900/9,600).
But if you buy 1 Call option contract for that stock instead (that gives the right to buy 100 shares), the cost will only be $600. When the stock price rises to $105, the option price may increase to $11 and you can then sell the option with a gain of $ 500 (=1,100–600) or 83% (=500/600).
As you can see, given the same number of shares, you get much higher % return using options (83%) than stocks (9%), although it is smaller in terms of actual dollar.

If, say, you buy 2 contracts of Call option for $1,200, you can gain $1,000, comparable to the dollar gain from the stock investment ($900). So, buying options allow you to gain the same profit as stocks would with only a much smaller capital and, therefore, at a much lower risk than buying stocks. In the worst case, if the stock crashes, the most you can lose is $1,200 and not the full $9,600.

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Why Options Trading? (Part 1)

There are a few reasons why people use options:

1. Require less capital

Options trading generally require less capital than the corresponding stock trading, because option price is only a small fraction of the underlying stock price. When a trader is confident that a stock price will move in a particular direction significantly within a short term, he can invest in options rather than in the stock itself to take advantage of the expected movement because of the limited risk, high potential reward and smaller amount of capital required to control the same number of shares of stock.

2. Protection

For an investor who invests in stocks, put options can be used as a hedging tool to protect your stocks from a price drop. When the stock price drops, the put option will increase in value, hence offsetting the loss in the stock. When the stock rises, the put option would simply expire worthless when the expiration date comes and you will only lose the price you paid to purchase the put options. So, here as if you buy put options as an insurance policy to protect your stocks from a price fall.

For an option trader, when the stock does not move in the expected direction, you should lose much lesser than a stock trader (in terms of dollar). Because the maximum you can lose is limited to the amount you spent to buy the option (premium), which is only a small fraction of the underlying stock price.

Click here to continue to "Why Options Trading? (Part 2)"

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