Option calls - getting started

[tonynyc]

Hello, I've been reading about options, and have applied for an option trading account, I want to see If I have this right, I see on Yahoo Finance that there is a Microsoft call option (MQFDE.X) it has a strike price of $5, and the premium is currently $10.99 it expires at close on Apr 17, 2009, so by the little research that I have done the numbers look like this: $10.99(premium) x 100(shares) = $1099 + $500(100 shares) = $1599, Microsoft closed at $18.13 x 100(shares) = $1813 if one would have purchased and exercised the option: $1813 - $1599 = $214 profit, do I have this right?

Thank you.

[grabiner]

Hello, I've been reading about options, and have applied for an option trading account, I want to see If I have this right, I see on Yahoo Finance that there is a Microsoft call option (MQFDE.X) it has a strike price of $5, and the premium is currently $10.99 it expires at close on Apr 17, 2009, so by the little research that I have done the numbers look like this: $10.99(premium) x 100(shares) = $1099 + $500(100 shares) = $1599, Microsoft closed at $18.13 x 100(shares) = $1813 if one would have purchased and exercised the option: $1813 - $1599 = $214 profit, do I have this right?

Your math is right (except for costs), but you got the wrong value for the option; this option is selling at $13.15 (ask price according to Morningstar), not $10.99, so you would have a $2 loss plus transaction costs if the stock price doesn't move, not a $214 profit.

Essentially, buying a deep-in-the-money option is equivalent to buying the stock except for the leverage. The option is guaranteed to be worth $5 less than the stock, unless the stock drops below $5, which is very unlikely; therefore, the option should cost about $5 less than the stock.

[maxwellthedog]

tonynyc-- your numbers are right but the idea won't work (unfortunately!). if you look at the yahoo finance page, you will see that the price is 10.99-10.99-- which means that the bid and offer are the same, which means this is a stale price. you can also see this where it says the change on the day is 0%. for an option this far in the money, it is not surprising that there is not trading activity. if there was a market, you would expect the option price to be at least (stock price) less (option strike) plus (option value).

[tonynyc]

Thanks for the replies, I knew it was too good to be true, with this new account I have to look for something to buy.

[livesoft]

I didn't look at any of the option quotes, but you should note that not all options are traded even if they are listed. That is, the volume is ZERO.

When I used options, only those options where there was a reasonable chance of the buyer AND the seller of making money had any kind of volume. That is, traders aren't stupid and don't like to throw money away.

So given that BOTH the buyer AND the seller have a chance of making money with any option you can trade, what do you think the average outcome is gonna be for you?

And it's also interesting to me that your first post to this forum (I guess the reason that caused you to register) is about a risky trading scheme that is pretty the exact opposite of what this forum is about. Why did you post here and not on an options forum? I'm intensely curious. Thanks!

[fmhealth]

Tony, Please consider SELLING CALLS rather than buying them. With a stock like MSFT, selling, IMHO, has FAR more accrued benefits. It's a strategy that will increase your cash flow with minimal risk.

Best of luck!!
FMH

[TheDan666]

The very fact that you even asked that question and had the info wrong should be proof enough that your next course of action should be canceling your options account. Sorry, I know this forum is supposed to be supportive and all but seriously I think you should reconsider what you are doing. I took an derivatives class in grad school and would never even consider trading them for my own account. Sorry to the be "that guy". Trade options if you want but keep in mind this is forum who, for the most part, see active trading as a fool's errand.

--The Dan

[Adrian Nenu]

http://www.cnbc.com/id/29913183

Here we go again - reminds me of the daytrading mania of the late 90's.

I agree with "The Dan". Stay away from options.

Adrian
anenu@tampabay.rr.com

[Horatio]

I like your question!
I've never traded options and never plan to. But it is still interesting to learn about them here. Gives me more confidence that "bogleheadedness" is a better direction for me, but not necessarily for everyone.

[Benn1950]

A wise person once told me there were four possible outcomes in buying call options - and three of them are BAD. If the stock doesn't move, you lose. If the stock rises, but not enough to meet the strike price, you lose. If the stock falls, you lose. Only if the stock rises ABOVE your strike price do you win. The same percentages apply to buying put options, only the stock price direction is different.

For what it's worth,

Jack

[Alistair]

... and in a fair market, the unlikely positive outcome means the price is low.

As always, don't gamble what you can't afford to lose. Because that's a pretty likely outcome

[cato]

I do a fair amount of covered option writing. If you are interested in trading options that's a safer way to go. You can write either Puts or Calls.
here are some scenerios:

#1 Expect modest moves in the market.
-----------------------------------------
Suppose I want to hold the S&P 500 index, but I'm thinking the market isn't going make big moves or may decline a bit.

At Friday's close I could buy SPY for 81.61 and write April 82 calls for $2.95. The possible outcomes on April 18 are:

1) SPY closes above 82 -- I make $3.34 ($2.95 + $.39). That's 4% in 3 weeks. But I forgo any gain beyond 82 and might miss a big run-up, because the stock gets called away.

2) SPY closes between 78.66 and 82. I make between $.01 and $3.34 and hold on to the stock. (maybe write more options)

3) SPY closes below 78.66 (a 4% decline). I keep the stock. This is the only scenario where I lose money.


#2 Pure income play
-------------------------------------
Suppose I just want to generate income. I could go really deep and write an April 74 call for $8.70.

1) SPY closes under $65.30 -- I lose $65.30 - SPY price

2) SPY closes above $66.40 -- I make $1.10.

In short, I do risk the "black swan" outcomes. But I get a virtually guaranteed $1.10 (82.70 - 81.61) return for taking that risk. That's a 16% annualized return.

_________________
Citigroup delenda est.

[SoonerSunDevil]

A wise person once told me there were four possible outcomes in buying call options - and three of them are BAD. If the stock doesn't move, you lose. If the stock rises, but not enough to meet the strike price, you lose. If the stock falls, you lose. Only if the stock rises ABOVE your strike price do you win. The same percentages apply to buying put options, only the stock price direction is different.

For what it's worth,

Jack

You don't have to hold your options until expiration to make a profit. I own 10 contracts (calls) on Jan 2011 BAC with a strike of $10. I purchased these contracts at an average of $1.45/share or $145/contract. Because BAC's stock price has climbed much higher than it was when I bought the options, my options are currently worth $3.15/share or $315/contract. Options trade just like stocks; they can be bought and sold with ease, although some options are not very liquid, so that must be considered. Options have the ability to allow investors access to cheap leverage, an ability to hedge their positions, and can be used as other forms of "insurance." After the meltdown buy, hold, and hope investors have suffered over the past year or so, I'm not so sure anyone should be bashing those who occasionally dabble in options.

[Dan Kohn]

In short, I do risk the "black swan" outcomes. But I get a virtually guaranteed $1.10 (82.70 - 81.61) return for taking that risk. That's a 16% annualized return.

You're following a well-known strategy known as "capital decimation partners".

http://calculatedrisk.blogspot.com/2008 ... erage.html
http://krugman.blogs.nytimes.com/2008/0 ... -partners/

It is very likely that your multiple years of nice returns will be more than wiped out when the black swan arrives. This strategy only makes sense if you're investing other people's money.

Citigroup delenda est

Ironic that you would say this when Citigroup was in essence following the same strategy of writing far out of the money puts.

[cato]

It is very likely that your multiple years of nice returns will be more than wiped out when the black swan arrives. This strategy only makes sense if you're investing other people's money.

That's utterly disingenuous.

You are confusing the use of deep-in-the-money covered options with using leverage. They do not have to go together. The simple reality is, with the strategy I outlined, if the ultimate black swan occurred (SPY goes to 0), I would lose 89%. Without the options, I would have lost 100%

Writing covered options is certainly not a free lunch. But it is is a completely legitimate way to put yourself in a different place on the risk-return curve. Contrary to most people's perceptions about options, it can put you on the less risky part of the curve.

[Dan Kohn]

Your example 1 was writing covered calls. That's a strategy that reduces volatility while capping your upside. I believe there is good academic research showing that buy-write is an inferior strategy to a Boglehead style asset allocation of stocks and bonds.
http://www.bogleheads.org/forum/viewtopic.php?t=10274

Your example 2 is, I think, writing naked calls. There is no faster way to lose money than writing naked calls. It is a ludicrously risky strategy. The lesson of capital decimation partners (which writes naked puts, but same idea) is that several years of success are more likely than not going to be followed by a blow up.

Original poster, if you don't understand every term and concept described here, please do not trade options. And, no one has even mentioned the greeks.

[market timer]

Your example 1 was writing covered calls. That's a strategy that reduces volatility while capping your upside. I believe there is good academic research showing that buy-write is an inferior strategy to a Boglehead style asset allocation of stocks and bonds.

It depends how risk is measured. If you use standard deviation as the measure of risk, buy-write strategies historically outperform stocks. You get about about the same expected return for much less variance. Standard deviation may not be the best measure in this case, since you miss the upside but bear most of the downside risk.

Here is a popular book on a the subject:

http://www.amazon.com/New-Insights-Cove ... 1576601331

[Adrian Nenu]

Wade Cook was a big proponent of options.

Adrian
anenu@tampabay.rr.com

[SoonerSunDevil]

Wade Cook was a big proponent of options.

Adrian
anenu@tampabay.rr.com

And Thomas Jefferson was in favor of slavery. What's your point?

[Adrian Nenu]

Every option strategy promoted focuses on the potential upside and tells virtually nothing about the risk involved. This is misleading but done to sell some strategy to naive speculators who dream of quick & easy riches. Wade Cook was one of the best examples.

Adrian
anenu@tampabay.rr.com

[cato]

Your example 2 is, I think, writing naked calls. There is no faster way to lose money than writing naked calls. It is a ludicrously risky strategy.

I guess I wasn't clear enough in the original post. It was supposed to be 1) Slightly out-of-the-money covered calls 2) Deep-in-the-money *covered* calls.

That's why I called 2) a "pure income play." You're trading away almost all the upside for a near-guarantee of collecting a premium that exceeds any losses in the SPY. You also get an absolute guarantee that you won't lose as much, if SPY goes down.

[SoonerSunDevil]

That's why I called 2) a "pure income play." You're trading away almost all the upside for a near-guarantee of collecting a premium that exceeds any losses in the SPY. You also get an absolute guarantee that you won't lose as much, if SPY goes down.

That's the biggest downside to your strategy; you're giving up the benefits of owning equities (the unlimited potential upside) for the immediate receipt of income. I've seen strategies that are much worse than what you're doing. I don't think that strategy is for me, but it might work just fine for you.

[cato]

That's the biggest downside to your strategy; you're giving up the benefits of owning equities (the unlimited potential upside) for the immediate receipt of income. I've seen strategies that are much worse than what you're doing. I don't think that strategy is for me, but it might work just fine for you.

Well it's a 16% annual return if I continue to roll it over, with only a black-swan risk. It seems like most other fixed income strategies have either vastly lower returns or vastly higher risk.

BTW, orget the academic studies. There's a buy-write index that you can compare called ^BXM. Since it was created in 1/2005, it has outperformed the S&P by ~20%.


Now for my next act I'm looking into buying Puts and (rarely) Calls on the leveraged and inverse ETFs. As most people know, these funds underperform over time because they reset their leverage every day. However, they can significantly overperform for short periods of time when the underlying index moves monotonically. Just tracking the prices over the last week or so, it looks like there's some opportunity for arbitrage between 2X and inverse 2X funds.