Part 1 attempted to explain the background of an option and why it was created. Part 2 will examine specific options (Calls) based on U.S. equities (stocks).
Most every stock in the market is ‘optionable’, which means you can buy and sell options based on that particular stock.
Every option has a specified ‘strike’ price and an expiration date.
I’d rather use pictures to teach you newbies this instead of bogging you down with financial terminology and definitions which you may or may not understand.
Regular taxonomy on options is sometimes convoluted and can be extremely confusing at times.
Let’s get into it!
In order to understand what a call option is you must first look at an equity that you want to buy an option on. So let’s just rock with Bank of America (BAC) for this post.
We’ll be using this chart periodically through this example…
Now, for most options, the strike prices will start at the whole numbers. So, for this particular stock you’ll get a $13 call, $14, $15 and etc. A call option generally goes UP in value as your stock moves higher. Now, I say generally because there are times where that actually will not happen. I’ll explain those examples in further detail after getting through the basics. Every stock has an option chain. We call it a chain because it basically give us the information for all possible options of the stock for a specific expiration date.
Below is the current option chain for BAC January expiration…
Looks confusing as hell I know, but with a few details and some repetition, you’ll be reading these chains like a superstar in no time. The first column is the strike price. Think of the strike price in terms of where you think the stock will go. So, for example, if I think BAC will rip to $16 next week, then I’d want to buy the $15 or $16 strike. The ‘Last’ column shows the last transaction that went off in the option and the ‘Chg’ column shows the change in price during the market that day. The ‘Bid’ and ‘Ask’ columns show where the best bid and offers are for the option. (Bid and Ask is something I’ll explain in further detail in future education posts.) The volume shows how many contracts were traded that day and the open interest is the total number of contracts that people are still holding on to. One last thing to remember is the expiration date.
All monthly options expire on the third Friday of the month, NO EXCEPTIONS!
Now, a simple way to understand the pricing of call options is to ask yourself how probable an increase in the stock price is likely to occur by the expiration date. Take a look at the BAC chart above and you can see that stock is currently at about $14.25. January expiration is on the 21st so let’s take a look back at the chain above at the $16 strike price. You can see that option is trading at $.04.
Why so low???
Because the likelihood of this shit happening is extremely low. Therefore, people ain’t willing to pay up for this so it’s trading pennies right now. If the stock were to say hit $15 on Monday, then there would be some renewed interest in this option and people would maybe pay up to $.10 for it. The important concept here is will said event happen BEFORE the expiration date. If you buy into the $16 Call and BAC is trading at $15.99 by the end of trading Friday, January 21st, your option is worth ZERO dollars.
Let’s do one more example…
The $16 Call is what we call ‘out of the money’ because the stock is below that strike price. Let’s take a look at an ‘in the money’ option like the $14 Call. Now the $14 call you can see is trading at $.54. Key thing to notice here is how much MORE the option price is above the currently value of the stock. If you take the option price and add it to the strike price ($.54 + $14.00) you find out how much ‘premium’ they’ve still tacked on to the option.
So $14.54 is how much over the currently stock price $14.25??
That’s about what $.29 right? That’s how much ‘premium’ is still in this thing. I think of it this way, “People are still assuming this stock could go higher to about $14.54. As the value of the stock goes up or down, so does this option respectively. People are constantly re-assessing their position and valuing their option as they go along according to what the stock is doing. So, on Monday, if the stock tanks to below $14.00 then you’ll see almost ALL the premium go away in this option. The LESS time that’s left before expiration the QUICKER you lose premium in your option. So if it’s at the beginning of the month, your premiums will stay high.
Let’s say for example tomorrow is expiration day. How much do you think this $14 Call would be worth assuming the stock was currently trading at $14.25??
That’s right folks! Exactly $.25!
Why is that?? That’s because there’s no premium left in the option. Time is up! These options expire tomorrow soooooo the option directly correlates with the stock price.
Part 3 will examine Put options… Make sure you check back daily for updates!
Stick with Lucci!