Sunday, February 12, 2012

Options – cash generator or money loser? Introduction

I have been trading options on and off over the years with mixed results. There is a lot of jargon such as spreads, straddles or intrinsic and extrinsic values. I bought a book… by Michael C. Thomset, a veteran option trader, titled ‘The option trading’s body of knowledge’ which was a disappointing affair of generalities combined with rudimentary explanations of various trading strategies. There are errors in the book’s arithmetic; it swings from the extreme basics of stock market investing to a vague valuation of the options themselves. Priced at $41.99 Canadian plus GST, this was definitely ‘out of the money‘?  Get the pun? No? Well I hope you appreciate this outlandish humor once you have read this posting series.

BTW, the spell checker just informed me that I don’t know how to spell arithmetic – How is that for an encouraging start! Johnny says, “Would you like to buy my car for $4000?” Bob replies, “Yes, but I don’t have the money right now. But you know what?  I’ll pay you $10 if you give me the right to buy it three months from now when my pay cheque is coming in. In the meantime, I will check out your car and if the price proves to be right, I may buy it.” Johnny:O.K. but… whether you buy or not, the $10 is mine”.

Ah, there you have it. Our first option trade! An option is the right to buy a thing for a specific price (strike price) within a certain time span starting now (term). Would that be worth something? Eh yeah! What do you think that the right to buy something for a fixed price is worth, eh? $10? Hmmm, that is the option ‘premium’ or price. 

So, I sell you the right (but not the obligation) to buy my car for $4000  (strike price) between now and three months from now for $10 (premium). If you find a buyer for my car who would be willing to pay $5000 for the car within that time period, then you made $1000 profit on a $10 investment.  If the option buyer does not find someone the buy the car, he/she has 3 choices: let the option expire and lose $10; buy the car for $4000 for his/her own use and/or sell it later on; or the option buyer 'rolls over' or extends the option - for additional premium of course.

The option buyer MAY buy the car; the option seller of the car MUST sell for $4000 unless the option term (e.g. 3 months) has passed. In the latter case he puts the $10 option premium in his pocket and sells or better ‘writes’ another option for another term. He might even use the opportunity to ask a higher premium for the car option, i.e. increase the sale price of the option. Of course, the option seller may also decide to change the car’s asking price or better the option’s strike price from $4000 to $4500 or $10,000. All kinds of possibilities and of course based on the seller’s choice of option features the premium offered by potential option buyers changes as well.

 You can do the same with stocks. You, the seller or option writer, can offer a call option to buy royal bank shares over the next few months, say until the 21st of April in 2012 for $56.00. You do not sell one such an option at a time, but you sell a contract for 100 shares and the option buyer may offer you $1.50 for each option in the contract. Thus the buyer’s bid price for the contract is 100x$1.50 = $150 plus a commission that goes to the option’s trading facilitators (typically the stock broker). The option writer receives $150 minus a commission; the broker(s) for this contract receives the buyer’s and seller’s commissions. An option to buy a share is referred to as a ‘call’. You can do the opposite and write an option that gives the right to sell at a pre-set price (strike price); this is called a ‘put’.

The symbol for the call option described above is RY C 21APR12 56.00 CA. Spelled out: Royal Bank Call option that expires on April 21, 2012 with a strike price of $56.00 per share traded on a Canadian stock market. This option is sold by the option writer and bought by the option buyer. The price is set by auction: the price offered by buyers is the bid and price acceptable to the sellers is the ask. When the ‘bid’ and ‘ask’ are the same, then the option is traded. Here is a screen shot from TD Greenline showing the option quotes:
Click on image to enlarge
This is ‘real time’ data, i.e. the prices for the latest bid and ask are shown for a single option in the option contract (a package of 100 shares) as well as the last price per option at which a contract was actually traded. The last traded contract sold for 100 x 0.43 or $43.00. Now, watch out here. The last trade may have occurred many hours ago and since that time the market may have changed dramatically and that ‘last’ price is often not really representative of the current market.

Only the highest bid (in this case $0.37 per option) is shown as well as the total number of contracts that are available at that price (Bid Size) is shown. Also shown is the lowest asking price ($0.43 per option) as well as the number of option contracts (10) offered for sale (Ask Size) at that price is shown.

 As said earlier, options are sold by the contract and each contract comprises 100 options (i.e. the right to buy or sell one share). Thus if the bid price of an option is $0.37, then the buyer wants to buy the contract for 100 x 0.37 = $37.00 (plus commissions).  Got it? 

There are often a lot more option offers (bids and asks) outstanding than those at the current highest Bid and lowest Ask price. The total number of outstanding options is called ‘Open Interest’ which counts in our example 4,925 contracts. The rest of the quote screen is straight forward and I guess does not really require further explanation (I assume).

We have now introduced the concept of an option in further posts we’ll dig deeper.

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