Wednesday, April 29, 2015

Understanding a Real Call Option

Now that you know how call and put options work, let’s take a look at some
real call and put options. Let’s pull up some quotes and see if we can make some
sense of what we’re looking at.
You can obtain option quotes for any optionable stock by going to www.cboe.
com. That’s the homepage for the Chicago Board Options Exchange (CBOE),
which is one of the largest option exchanges in the world. Bear in mind that the
options market is open from 9:30am to 4:02pm ET (it is open until 4:15pm ET for
index options). If you are pulling up quotes after 4:02pm, you’re looking at closing
prices rather than live quotes. Also, options go through what is called an opening
rotation every morning. This is simply an open outcry system that establishes option
prices based on the current stock price openings. For this reason, you may not see
live option quotes until 9:35 or 9:40 even though the options market is technically
open at 9:30.
If you click on “Quotes” and then “Delayed Quotes” you will find a box where
you can type your stock ticker symbol. If you are looking for options on eBay,
for example, just type the ticker symbol “EBAY” and hit enter. At this time, the
shortest-term options on eBay were July ’05 (26 days until expiration) and the
longest term was January ’08 (943 days to expiration). The lowest strike is $22.50
and the highest is $80. So even though option contracts are standardized, there are
many to choose from. Table 1-1 shows some of the shorter-term options available
at the time of this writing:
Table 1-1: EBAY Option Quotes
Before we continue, we need to introduce some more terminology that has
been deliberately withheld until now for the fact that it will be easier to understand
at this point. There are three main classifications for options. First, there are two
types of options: calls and puts. Second, all options of the same type and same
underlying represent a class of options. Therefore, all eBay calls or all eBay puts
(regardless of expiration) make up a class. Third, all options of the same class, strike
price, and expiration date make up a series. For instance, all July $32.50 calls form
a series.
At the time these quotes were taken, eBay stock was trading for $37.11, which
you can see in the upper right corner of Table 1-1. The first column is labeled
“calls” and several columns to the right you will find one labeled “puts.” The first
call option on the list is 05 Jul 32.50. The “05 Jul” tells us that the contract expires
in July ‘05 and the “32.50” designates that it is a $32.50 strike price. The last
trading day for this option will be the third Friday in July ‘05. All you have to do
is look at a calendar and count the third Friday for July ‘05 and that is the last day
you can trade the option (which happens to be July 15 for this particular year).
Remember, you can buy, sell, or exercise this option on any day, but the last day to
do so is July 15. All 05 July options will expire on the same date regardless of the
strike price or whether they are calls or puts.
The “XBAGZ-E” notation is the symbol for that option. Just as every stock
has a unique trading symbol, each option carries a unique symbol. However, you
can forget about the “dash E,” as the letter E is a unique identifier for the CBOE,
which just tells us these quotes are coming from that exchange. If you wanted to
buy or sell this option online, you’d enter the symbol “XBAGZ.” Your broker,
however, may require you to follow this symbol with “.O” to show that it is an
option (for example, XBAGZ.O). Your broker will make it very clear if he has these
requirements, but the actual symbol (XBAGZ in this example) will always remain
the same regardless of which brokerage firm you use.
The $32.50 strike means that the owner of this “coupon” has the right, not
the obligation, to buy 100 shares of eBay for $32.50 through the third Friday of
Jul ‘05. No matter how high a price eBay may be trading, the owner of this call
option is locked into a $32.50 purchase price. Now this seems like a pretty good
deal since the stock is trading much higher at $37.11. It appears that if you got the
$32.50 call, you could make an immediate profit of $37.11 - $32.50 = $4.31. In
other words, it appears that if we could get our hands on this coupon, we could
buy the stock for $32.50 and immediately sell it for the going price of $37.11
thus making an immediate profit of $4.31. However, you must remember that call
options, unlike pizza coupons, are not free. It will cost us some money to get our
hands on it.
How much will it cost to buy this coupon? We can find out by looking at the
“ask” column, which shows how much you will have to pay to buy the option. It
shows a price of $4.90 to buy this call. This means the apparently free $4.31 is no
longer free since you’re paying $4.90 for $4.31 worth of immediate benefit. In fact,
you will find that you must always pay for any immediate advantage that any call
or put option gives you. The main point is that you cannot use options to collect
“free money” in the market. When traders are first introduced to options, they
often think they can buy a call option that gives them an advantageous price and
then immediately exercise the call for a free profit. They overlook the fact that the
price of the option will more than reflect that benefit. Why would someone pay
$4.90 for $4.31 worth of immediate benefit? Because there is time remaining on
the option. It is certainly possible that the option will, at some point in time, have
more than $4.31 worth of benefit, and traders are willing to pay for that time.
The $4.90 price is also called the premium. The premium really represents the
price per share. Since each contract controls 100 shares of stock, the total cost of
this option will be $4.90 * 100 = $490 plus commission to buy one contract. So if
you spend $490, you can control 100 shares of eBay through the expiration date
of the contract. That’s certainly a lot less than the $3,711 it would cost to buy 100
shares of stock. If you buy two contracts, you will control 200 shares and that will
cost $980 plus commissions, etc. Remember, we said that all options control 100
shares when they are first listed but it is possible for them to control more shares,
which is usually due to a stock split. If that happens, it is possible for the contract
size to change, which we will expand on more in Chapter Four. The main point
to understand is that you always multiply the option premium by the number of
shares that the contract controls in order to find the total price of the option. In
most cases, you will multiply by 100.
Bid and Ask Prices
Let’s take a brief detour here to learn more about what the bid and
ask represent since they can be confusing to new traders. Notice that
the $32.50 call shows a bid price of $4.70 and an ask price of $4.90.
You have to remember that the options market, just like the stock
market, is a live auction. There are traders continuously placing bids to buy and
offers to sell. The bid price is the highest price that someone is willing to pay at
that moment. The asking price is the lowest price at which someone will sell at that
moment. If these terms are confusing, think of the terms you use when buying or
selling a home. If you wish to buy a home, you submit a bid. Buyers place bids.
If you were selling your home, you’d say I am “asking” such-and such a price for
it. Sellers create asking prices. Sometimes you will hear the word “offer” instead of
“ask” but they mean the same thing. If the bid represents the highest price someone
is willing to pay that means you can receive that price if you are selling your option.
You are selling to a buyer and the trade can get executed. Notice that you cannot
sell at the $4.90 asking price because that is a seller too and you cannot execute a
trade by matching a seller with a seller.
Likewise, if you are buying this option, you should refer to the asking price to
see how much it will cost you. Since the asking price shows the lowest price that
someone will sell, we know you can buy the option for that price. In this case,
you are buying from a seller and the trade can get executed. This is important to
remember since the price you pay or receive depends on the bid and ask. This trade
may appear to be a good deal if you can sell for $4.90 but you will be disappointed
if you find that you only receive $4.70. You need to be aware of which price applies
to your intended action. In summary, if you are selling then you should reference the
bid price. If you are buying, you should look at the asking price. This is especially
critical for options traders since the volume on options is not as high as it is for the
stock and, consequently, options will have larger spreads between the bid and ask.
For example, in the upper right corner of Table 1-1, you can see that the stock is
bidding $37.10 and asking $37.11, which represents a one-cent spread between
the buyers and sellers. However, the $32.50 call option is bidding $4.70 and asking
$4.90, which is a 20-cent spread. The bigger that spread, the more critical it is to
understand what these numbers mean, otherwise you could be in for an unpleasant
surprise when trading. We’ll learn more about the bid and ask in Chapter Four
when we examine the Limit Order Display Rule and how you can use it to your
advantage to lessen the effect of the spread.
The “bid” price represents the highest price that a BUYER is willing to
pay. It is consequently the price at which you can sell the option.
The “ask” price represents the lowest price that a SELLER is willing to
receive. It is consequently the price at which you can buy the option.
Okay, let’s try the next call on the list in Table 1-1, which is the 05 Jul 35 call
(notice that the strikes are in $2.50 increments since eBay is below $50, which is
in agreement with what we stated earlier). If you buy this call option, you have the
right, not the obligation, to buy 100 shares of eBay for $35 per share through the
third Friday in July ‘05. Since eBay is trading for $37.11, we know that anybody
holding this option has an immediate advantage of $37.11 - $35 = $2.11 by buying
this call and we now know that this advantage must be reflected in the price. You
can verify that the asking price is $2.70, which shows the apparently free $2.11
benefit is not free. Again, the reason traders will pay more than the $2.11 benefit
is because there is time remaining on the option and it certainly could end up with
more value. If you want to buy this contract, it will cost you $2.70 * 100 shares =
$270 per contract + commissions. If you buy two contracts, you will control 200
shares and that will cost $540 and so on.
While we’re talking about the prices in Table 1-1, let’s explain what the rest of
the columns mean. The LAST SALE column records the price of the last trade of
the option. Option traders rarely look at this, since that price could have occurred
during the last minute but it also could have been last week. We don’t know when
that trade took place. We just know that was the price when it last traded. For stock
traders, the last sale will generally be very close to the bid and ask of the stock,
because optionable stocks generally have high volume – but that is not necessarily
true for their options. In Table 1-1, you can see that the last trade on eBay was
$37.11 with the bid at $37.10 and the asking price at $37.11. The last sale for
the stock is very close to the current bid and ask, which will usually be the case.
But notice that the last trade for the $32.50 call was $4.40 with the bid and ask at
$4.70 to $4.90. This shows that the last trade is somewhat stale; that’s why option
traders generally do not look at the last trade. If you were buying this option, the
last sale would lead you to believe that it would cost $4.40 when it would really
cost $4.90. If you were selling the option, the last sale may make you decide against
it since it appears you would only receive $4.40 when, in actuality, you get $4.70.
The NET column shows the difference, or the “net change,” between the last
trade and the last closing price just as it does for stocks. For the July $32.50 call, the
last trade was $4.40 and that price was down $1.20 from its previous price, which
means the previous trade was $4.40 + $1.20 = $5.60. If this option traded at $5.60
and the next trade was at $4.40 then that represents a $1.20 drop in price, which is
what the NET column shows. Again, the reason for the apparent big drop in price
is because there was a big time delay between those two trades.
The VOL column shows us the volume, which is simply the number of
contracts traded that day. For the stock market, volume refers to the number of
shares traded; for the options market, it refers to the number of contracts but the
idea is the same.
The OPEN INT column shows how many contracts are currently in existence,
which is called the “open interest.” We’ll find out more about open interest in
Chapter Four.
A brief explanation, however, is worth mentioning here. When you buy or sell
a contract, you must specify whether you are entering or exiting the contract. If
you are entering into the contract (or increasing the size of an existing position)
then you are “opening” the contract. However, if you are exiting the contract (or
decreasing the size of an existing position) then you are “closing” the contract.
Most brokerage firms require that you specify whether you are opening or
closing the position. For instance, if you wish to buy 10 Microsoft July $30 calls
you would enter the order as “buy to open” 10 Microsoft July $30 calls. You would
not say “buy” 10 Microsoft July $30 calls. The reason is that the word “buy” alone
doesn’t tell the broker if you are buying the calls to own them (opening transaction)
or if you are buying the calls to close a short position (closing transaction). Using
the words “to open” or “to close” clarifies your intentions.
Some of the newer firms do not require the use of the words “opening” or
“closing.” Instead, they account for it based on the existing positions in your
account. For instance, if you have no Microsoft July $30 calls then the above order
is recognized as an opening transaction. On the other hand, if you were short 10
Microsoft July $30 calls then the order is recognized as a closing transaction.
Every time the buyer and seller are entering an “opening” order it adds to the
open interest. For instance, if you are buying 10 contracts to open and the seller is
selling 10 contracts to open, then open interest is increased by 10.
If the buyer and seller were, instead, both entering “closing” transactions, then
open interest would decrease by 10 contracts. Finally, if one is “opening” while the
other is “closing,” then that order has no effect on the open interest.
Open interest provides a measure of how many contracts are currently in
existence and therefore provides a measure of liquidity. That’s what the open
interest column shows.
Understanding a Real Put Option
Now that we’ve looked at a couple of call options, let’s take a look at some real
put options. In Table 1-1, what does the 05 Jul 32.50 put option represent? If you
buy this put, you have the right to sell 100 shares of eBay for $32.50 per share
through the third Friday of July ’05. For that right, you would have to pay 0.20 *
100 = $20 plus commissions. No matter how low a price eBay might be trading,
you are guaranteed to get $32.50 if you exercise this put option to sell your shares.
Remember, you do not need to own the shares of stock to buy a put. By purchasing
this put, you have the right to sell shares for $32.50 and somebody else will be very
willing to buy this from you if eBay falls below $32.50. By purchasing the put,
you’re banking on eBay’s price falling. If you think the price of eBay will fall, you
can buy the put and then sell it to someone else, thus capturing a profit without
ever having the shares to sell. Notice that with this option, there is no immediate
benefit in owning the $32.50 put. If you owned shares of eBay and wanted to sell,
you’d just sell the shares in the open market for $37.11. Once again, the reason
there is any value to this $32.50 put at all is because there is time remaining and
it may end up with a lot more value if eBay’s price falls. Traders are willing to pay
for that time.
Let’s try another one on the list, the July $37.50 put. If you buy this put, you
have the right to sell 100 shares of eBay for $37.50 per share through the third
Friday of July ’05. Now this put does appear to have an immediate value since we
could sell the stock for a higher price than it is currently trading. It appears that
if we buy this put, we could buy the shares for $37.11 and immediately use the
put option and collect $37.50 for an immediate guaranteed profit of 39 cents.
As with our call option examples, any immediate benefit must be paid for, and
we can verify that by observing the 50-cent asking price. In other words, you’re
paying 50 cents for that 39-cent benefit. The market is willing to pay more than
the immediate benefit since there is time remaining on the option. You cannot use
options, whether calls or puts, to collect “free money.”

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