Help understanding options

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cayden
Posts: 5
Joined: Sun Nov 02, 2014 10:21 am

Help understanding options

Post by cayden »

Hello all! I am trying to understand options and I am sure that I am not understanding something.

Here's what I think I understand:
  • Put options allow the underlying security to be sold at the strike price
  • Call options allow the underlying security to be purchased at the strike price
  • Each option contract allows 100 shares of the underlying security to be bought / sold
  • The strike price is the price that each share of the underlying security can be bought / sold
Consider the following example:

HD - Nov 2016 - PUT
Bid 62.05 Bid Size 96
Ask 65.80 Ask Size 45
Strike Price 195.00

In my limited understanding, this means that I can purchase 1 contract for $65.80 and then in Nov 2016 sell 100 shares of HD for $195 each. Given that HD is currently trading for 131.85 that would equate to a gain of over 47% (195*100-65.80)/(131.85*100) in 6 months.

I'm sure I am misunderstanding something because the numbers are too good to be true! Could someone please point out my error?

I suspect that I am mis-interpreting the price of the contract and it's actually 65.80 x 100, thus I am paying $65.80 per share; betting that the price will be 195 in 6 months.  I'm not sure why I would do this though; as the share price would need to appreciate to $197.65 (131.85 + 65.80) for me to even break even.
alex_686
Posts: 7847
Joined: Mon Feb 09, 2015 2:39 pm

Re: Help understanding options

Post by alex_686 »

While options are normally 100 shares per contract, the premium is quoted a per share.

So the correct formula would be closer to this: (192/(65.80+131.85). There is $5.65 time value & volatility in the contract. This feels slightly off - I would have guessed it would be smaller.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
ralph124cf
Posts: 2653
Joined: Tue Apr 01, 2014 11:41 am

Re: Help understanding options

Post by ralph124cf »

Purchasing a put contract means that you are betting that the price of the stock will go DOWN. As the previous poster mentioned, the intrinsic value of the contract is the difference between the current price and the exercise price. If the current price is $132/share, and the exercise price is $195, then the intrinsic value of the contract is (195 - 132 = 63) $63/share. So you would have to pay $6,300 for the intrinsic break even price. No writer of a put option would take such a low price, all would want a higher premium, so $65 or $70 would not surprise me as a current price.

One thing that you seem to have backward: You are saying that the price would have to INCREASE for you to break even. Actually, the higher the price gets, the more money you lose on the trade. You want the price to go DOWN, so the value of the option will increase.

If you want to bet on a price increase, you would buy a call, not a put. Looking at current quotes, the November 2016 HD call has an asking price of 5 cents, so you would be paying $5, plus commission for the right to buy 100 shares at $195/share. If you feel confident that the stock will go significantly above $195 by November, it is a cheap gamble.

Just don't consider it an investment.

Ralph
t3chiman
Posts: 87
Joined: Wed Mar 18, 2015 12:34 pm

Re: Help understanding options

Post by t3chiman »

cayden wrote:...I am trying to understand options ...
CBOE has gobs of information on options and option trading strategies. Generally speaking, options buying is considered very non-Bogleish, because some 90% of options issued expire worthless. The leverage they offer can be attractive, however. And hope springs eternal, as the poet says.

But, flip the coin around, and act as seller of options contracts. Then, you are sitting pretty. All you have to do is find a nice stock, buy it, and sell a covered call a few bucks higher in price. You get your immediate premium, and the excitement of watching the price of your underlying stock fluctuate in the time till option expiration date. Then, depending on the difference between your stock price and the option strike price, you are happy or sad.

The reality: it is tough to make lots of money as an amateur options trader. But the game is actually played pretty straight. If you are not greedy, you can make a few percentage points extra on your holdings, as compared with just sitting there.

HTH
rai
Posts: 1310
Joined: Tue Apr 06, 2010 7:11 am

Re: Help understanding options

Post by rai »

I have been selling options (mainly puts) for several years and making a decent profit. It's certainly not for everyone and not something I'd advise someone else to do.

BUT overall (IMO) selling puts (low out of the money puts) is not horrible. Just as an example I could sell a put Jan 2017 for Tesla $100 that would pay $200/contract ($2/share). Tesla is selling now at $220/share. So IOW Tesla would have to go down to $100a share in the next 8 months in order for the contract to execute and down to $98/share for me to lose money. (IMO this is possible but not very likely).

Now, you have to be aware that no matter how far out of the money you go, there is a chance that the option can execute. But I've found that low out of the money puts rarely execute. I would say that the 95% do not execute is probably safe to say.

I would not recommend to most people, but it is a way to earn something for not a lot of risk.

Another is to sell covered calls. This would be for example if you own the shares like AAPL that's at $95/share. You could sell a call in the future like January 2017 that would be AAPL $105 and you could pocket $5.5/share. So IOW sell one contract for $550 dollars and if Apple does not break $105/share you just keep the money (plus the $114 in dividends in the next 8 months). So you'd be pocketing $114 (dividends) plus $550 (option) and only if the shares broke $105 ($1000 profit) would the order execute.

So on $9500 of APPL shares (most options contracts are for 100 shares) if the price of Apple went to $105.1 and the contract executed you would make $1000 + $550 + $114 = $1664

Which is over 8 months you'd be capped at 17% profit for 8 months.

If it doesn't execute, you still keep the stock, you still keep the dividends and you still keep the option premium so around 6% gain (option premium and dividend).

Now that's the maximum profit, if Apple went up to $150 you'd be missing out on a lot of profit.

I don't generally sell covered calls, because my shares are in a taxable account so if they do execute, I am forced to see at a sizable taxable gain (tax). So to me it's not worth the small premium. I mainly sell puts (low out of the money) on stocks that I might want to own anyway if they were cheaper.
"Life is what happens to you while you're busy making other plans" - John Lennon. | | "You say that money, isn't everything | But I'd like to see you live without it." - Silverchair
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