I our last post we wrote about how Cindy pulled off a deal of a lifetime in a manner very similar to buying a call option. If you haven’t read that post yet it may be helpful to do so since I will be using the same analogies throughout this discussion. Armed with a fundamental understanding on how buying and selling a call option works, the next step is to understand the language around the sale and the numbers. Sticking to our black dress analogy, we need to be able to read the price tags. In the case of options, the price tag is called an option chain. Every stock that has options associated with it has its own unique chain. A good place to find a stock’s option chain is on Yahoo’s Finance site. Put in the symbol of the stock you are interested in within the “Get Quotes” text box and the stock’s summary page will appear. If you can click on the “Options” link in the left-hand toolbar, then the stock in question has options associated with it.
The chart below is the option chain for Map Pharmaceuticals (MAPP) as of February 8, 2012. If you follow Rallytype’s public predictions it may sound familiar, since we have mentioned it. If you were to go to Yahoo Finance yourself you would note that I am only showing one of the two charts presented – the call options chart. For now, this is what we are interested in – the ability to buy a slip of paper which gives us the option to buy stock in the future just like in the dress analogy.
Options are available for different expiration dates. As you can guess the more out the expiration dates are the more potential they have to make money and the more expensive they are. In the example below we are looking at options that expire on June 13, which is about four months out from this date of writing.
Each option has a unique ticker symbol, just like the stock it is associated with. Although there are a lot of letters and numbers involved and the symbols may be quite confusing to look at, there is some rhyme and reason to all of it. Looking at the symbols closely you can make out information such as the stock symbol MAPP, the date the option expires and such. In this age of online trading, it’s all about clicking links anyway so don’t make yourself crazy on learning what every letter and number means.
The Strike Price is the price at which you the option holder (buyer) would be given the option to buy the underlying security before or on the expiration date. In the case of the dress analogy, this is how much we are willing to buy the dress for in the future. You will notice that some of the options are highlighted in yellow. These options are currently “in-the-money”. In the money options are those that today have intrinsic value. You could exercise the option today and buy the underlying security for less than what it is currently going for. Like we discussed in our last post, these options had their “Beyonce Event”.
The Last Price is the price at which that option last traded at. Note that options trade in blocks of 100 shares called contracts and options are priced per share. So to figure out how much the option would have cost you, you need to move the decimal point over two spots. A 22.50 strike price option in this example has a last price of 2.50 and cost the person who bought it paid $250. The Change Price is simply the change in price in the options between now and the market close yesterday. The Bid Price is how much you could get paid to sell the option if you owned it (remember to move the decimal points) and the Ask Price is the price that you would have to pay right now to buy the option. You would think that in all cases that the Bid Price and the Ask Price would be the same, right? Just like at the department store where the store puts a tag on a dress and a buyer plops down their credit card for that amount of money and takes it. Markets don’t actually work that way. There are folks behind the scenes who make trading possible and like all folks who make a living, they get paid. These people are called market makers and you can think of them as the middle men who buy the dress from the wholesaler and sell them retail.
The Volume is important metric to follow before you pull the trigger on buying a contract. The volume number of contracts traded during the trading day so far. You need to always keep in mind how many folks are interested in buying your option when you feel it is time to sell it. If you can’t find a buyer before the expiration date you are on the hook for either buying the stock when the option expires or walking away with nothing. The Open Interest tells you how many contracts are outstanding, meaning they haven’t been exercised yet. Most times when the Volume comes close to the Open Interest, a “Beyonce Event” occurred and the stock is moving upwards so the extent that the option is close to or in the money.
Let’s muddle up what you have learned so far with some math. Suppose it is March 2013 and you see a tweet from @Penny__Logic citing a new public prediction that MAPP may move 9% in the next 10 days. With MAPP currently trading at 24.89, an 9% bump would move it up to a little above 27. After doing your own extensive due diligence you think that this prediction may be right. Looking at the June 13 options chain you note that you can buy a call contract with a strike price of 25 for $5 (0.05 listed x 100 options per contract). Suppose in about two weeks’ time the stock does indeed go up to 27. How much is your option worth. A good “guesstimate” would be a little bit more than $200. The option is $200 in the money, meaning it is worth $200 in the then in now. There would be some additional premium you could get for it because the stock can still go up between now and June. Imagine if you bought 10 contracts for $50? You’d be sitting on $2000. Not too shabby.
Guesstimates are nice, but having more insight on your risk and reward before pulling the trigger on an option is even better. In our next post on the topic, I’ll talk about using an options calculator. They are online, they are free and will do you a whole lot of good.
Happy Trading!
-Russ