Lessons from the Pros


Options for Newbies – Part 3

This is installment three in our “Options for Newbies” series. In this series I am going through the subject of options in the most basic way, to help give those new to options a starting point. Even if you’re a veteran, these articles may give you a deeper understanding of some aspects of options.

Breaking news: Last week Peter Glazebrook of Nottinghamshire, England claimed the record for the world’s largest onion, by growing one weighing in at 17 pounds, 15 ounces.  Figure 1 below shows a proud Mr. Glazebrook with his prize onion, which handily beat the previous record of 16 pounds, 8 ounces.

Figure 1 – a giant onion

Say what?? What does this have to do with options? Well, to a beginner, the subject of options is huge, mysterious, and can make your eyes water. In this series, we’re peeling away at that onion, one layer at a time.

In the first two installments, which you can review here and here,  I began this peeling process by way of an example using call options on the stock of Apple Inc.  Let’s look at how that position would have done, and then use that as a jumping-off place for peeling back some more layers.

Our example options were the September 650 Calls.  Each one of these option contracts gave its holder the right to buy (because it was a Call and not a Put), 100 shares of Apple stock (the underlying asset), at $650 per share (the strike price), up to the close of business on Friday, September 21 (the expiration date).  This particular option was just one of many at different strike prices and expiration dates that were available at the time. Each option has its own symbol or ticker, to differentiate it from all others.  For these options, the symbol was AAPL 120922C650.

That symbol is long, but it is easy to interpret.

AAPL is the root, and indicates the underlying asset. It is the symbol for the stock of Apple, Inc.

120922 is the date on which the option is settled, in the format YYMMDD. It’s the day after the expiration date, which in this case was September 21, 2012. This settlement date is when the underlying asset will change hands, if that happens (it doesn’t always happen).

C is because this option is a Call. For Puts, this position has a P instead of a C.

650 indicates the strike price of this option.

Put them all together and you have AAPL 120922C650. The space after the root is part of the symbol. Note that depending on the source you’re looking at, sometimes the symbols are given slightly differently, with more leading or trailing zeroes. Nasdaq.com, for example, would display this symbol as AAPL 120922C00650000.

Fortunately, when we’re trading options we just pick our strike and expiration from a table, and we never have to type the symbol.  This table is called the option chain, and we’ll look at it later.

Back to our example.  At the time of the writing of the first article on August 29, Apple’s stock was at $673.40. The 650 calls were quoted at $27.60. As you’ll recall, although each option contract is for 100 shares of stock, the prices of the option contracts are quoted in dollars and cents per share. The cost to buy each contract is 100 times the quoted price. So in this case, each Call option contract gave the right to buy 100 shares of stock at $650 per share (a total of $65,000).  Each such contract cost 100 times $27.60, or $2,760.

At the market close at 4:00 PM Eastern time on expiration day, September 21, Apple was at $700.09. Since anyone who still held the 650 calls after the close was going to get Apple stock for $650 (whether they wanted it or not), each of the September 650 calls at that time provided a discount to the market price, equal to $700.09 – 650.00, or $50.09 per share. In option parlance, these options finished in the money by $50.09. This amount was their intrinsic value. Within a few pennies, $50.09 is the price at which those options had to close. In fact they closed at $50.00 even, just 9 cents away.

Why did these options have to finish near $50.09 per share? Here’s why. Remember, there was no time left for these options. They were about to cease to exist. No further increase in the price of the stock was possible in their lifetime. So their intrinsic value – the amount of discount they offered- was never going to be any higher than it was. At that last moment, with the stock at $700.09, anyone who paid more than $50.09 for the options was guaranteed a loss.  So no one would bid more, and the options couldn’t close higher than that.

They also couldn’t close much lower. Arbitrage is buying and selling the same thing simultaneously in two different markets for a risk-free profit.  Anyone who paid less than $50.09 for those options at that moment had an opportunity to do that. They were guaranteed a profit if they could simultaneously sell Apple stock short for $700.09. Those last few buyers of the options (and somebody had to buy the last ones that were sold) almost certainly did just that: Buy the options for $50, and therefore have a contractual right to the apple stock for $650, for a total invested of $700 even per share; sell the stock for $700.09, for a guaranteed profit of 9 cents per share. Nine cents is a pretty thin margin on $700, a little more than a hundredth of one per cent. But to certain deep-pocketed traders with low trading costs, mainly banks and institutions, that margin is sufficient, given that it’s risk-free. If the options were selling for less than $50.09, then the margin of risk-free profit would be higher. In that case, other traders would find it worth their while to buy the options, and they would bid the option prices up. Shortly they would reach those prices where they could only be bought by the big guns – the intrinsic value, minus a few cents. At that price they stop.  Similarly, the $700 calls that expired that day with $.09 in intrinsic value went out (last traded before the close) at $.05.

OK. As all expiring options must do, the $650 September calls ended up at or very near their intrinsic value, which is the amount by which they are in the money.  In this case they ended up at $50. For those who had bought them on August 29 at $27.60, the profit was $22.40 per share, or $2240 per contract –  about 81% in 23 days. Of the other people who owned those calls at the close, those who had paid anything less than the closing price of $50.00 made a profit, and those who had paid more had a loss. There were plenty of both, since that option traded tens of thousands of contracts during its lifetime at prices from $1.60 to $55.01 per share.

What about September call options to buy at prices higher than $700? There were thousands of them outstanding at the close on September 21, and they had no intrinsic value. Well, when expiration comes around, an old saying (which I just made up) applies: “When you got no time left, if you ain’t got no intrinsic value, you ain’t worth nothin’.”  All of these out-of-the-money options went out worthless (could not be sold for any price), and everyone who still held them lost everything they paid. Bad news for them, good news for the people who sold them those high-strike calls. Those call sellers will be our subject next time.

If you have any comments or questions about this article, contact me at rallen@tradingacademy.com.



DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Join over 170,000 Lessons from the Pros readers. Get new articles delivered to your inbox weekly.