Lessons from the Pros


Options Mailbag – Breaking Even and Crossing Over

In last week’s article, which you can read here, I wrote about calculating break-even prices for option positions. I received a message from a reader asking for clarification on some of the points discussed there. The reader’s questions make a good framework for clarifying and expanding on those points.

This is a good place to note that these articles in themselves cannot, and are not meant to, make anyone an expert option trader. That requires specialized, in-depth education, of the kind provided in our Professional Options Trader course and its companion Extended Learning Track program. By the way, that course has just been completely re-designed, and is better than ever. It now features actual in-class trading practice. There is a clearer and more comprehensive treatment of each strategy presented, and many, many more improvements.  If you’ve been waiting for the right time to get a proper education in options, this is it. The counselors at your local centers can give you all the details.

Back to the questions raised by the reader:

Question: In the second paragraph you write this:

“For example, we might pay $2.00 for a one-month call option at the $100 strike price.”

Should that not read at the $102 strike price? Also, who or what determines the option price as in this case of $2.00, why not $3.00 or $1.00?

Answer: No, I intended to use the $100 strike price. That is, the option that gives its buyer the right to purchase the stock at $100 (which happens to be its current price) at any time in the next month. The reason that the option has any value is that the stock has a month to go up in price. If it does, then having the right to buy it at a fixed cost (the $100 strike price plus the $2.00 cost of the option in this case) could result in a profit.

As to why the price I used was $2.00 and not something else, this was just one plausible example; in fact the price of such an option might well be $1.00 or $3.00, or even $10.00. What a particular option will sell for depends on what value the call buyers and sellers are willing to agree to assign (by actually buying/selling the calls) to the chances that the underlying stock will go up in price. The bigger the expected move, the more the buyers will be willing to pay. There is a formula that determines the theoretical price of an option, based on how far it is in or out of the money; how long it has to run; and how volatile the stock has been in the past.  That theoretical price is a starting point for pricing of any given option.  But in the marketplace, traders may be willing to pay more or less than that theoretical price, depending on their opinion as to likely price movement. As always, the supply and demand in the marketplace (for the options) determines the actual price.

Question: Is there an amount of shares attached to a call or put option? You say for a covered call we need to buy the stock at $100.00, but how many shares?  

Answer: Each option has a multiplier. For options on stocks, the multiplier is almost always 100 shares per option contract, and is assumed to be so in these articles unless otherwise specified. In the covered call example, the call buyer would need to buy (if he did not already own) 100 shares of stock at $100 each, in order to be able to sell one call option. So he would pay out $10,000 for the 100 shares of stock; and then receive $2.00 times 100 shares, or $200 for selling the call option. His net cash out of pocket would be $10,000 – $200 = $9,800. His net cost of the covered call position would be $98.00 per share in that case.

Note: Recently a few stocks and exchange-traded funds have begun trading mini option contracts that cover 10 shares rather than 100. For these stocks, one could buy 10 shares and then sell one mini-contract call option against them. At the moment, the items with available mini-contracts are Google (GOOG), SPDR Gold Trust (GLD), Amazon (AMZN), Apple (AAPL) and the SPDR S&P500 ETF (SPY).

Question: Looking at the Vertical Spread example, where we buy no stock, but instead buy a call option at the $95 strike for $6.00, and sell a call option at the $100.00 strike for $2.00. If we spin the price scenarios a bit further as follows, would this be correct?   

At expiry date we assume various stock prices:

Stock Value Call Option $95.00 Buy Call Option $100.00 Sell Initial Outlay P/L
99.00 +4.00 $0.00 -4.00 0.00
96.00 +1.00 $0.00 -4.00 -3.00
95.00 0.00 $0.00 -4.00 -4.00
100.00 +5.00 $0.00 -4.00 +1.00
101.00 +6.00 $-1.00 -4.00 +1.00
103.00 +8.00 $-3.00 -4.00 +1.00

Question: It seems on the upside of the stock price we are always in the money by $1.00. However at lower stock prices we continue to lose with the stock price. Is there a scenario where we are also always in the black?

Answer: Your calculations are correct for the prices shown. The maximum profit we could make on this trade is $1.00 per share, or $100 per contract. At an expiration-day price of $95, there would be a loss of $4.00 per share, or $400 for the contract. What is not obvious from these prices is that the $4.00 loss is the worst we could do at $95 or any lower price, even if the stock went to a value of zero. If the stock price at expiry is at or below $95, then both options are worthless, and we just lose our $4.00 debit.

Remember that in this example, we were starting from a point where the stock was at $100. For the vertical spread to make its maximum $1.00 per share profit, the stock did not have to go up. All it had to do was not go down. If it stood still at $100, the profit would be $1.00 as shown in your table. In fact, the stock could go down by as much as $ .99, and this bullish position would still make some profit.

Secondly, the fact that $95 is the price at which our maximum loss would occur, does not mean that we would plan to wait for that to happen. As with any trade, we would identify a stop price, at which we would exit the trade. In this case, we might well plan to unwind the trade (buy back the short $100 call and sell the $95 long call) if the stock price dropped, say to $99. We would determine the exact stop price in the same way as we would if we were simply buying the stock at $100.

As to your last question:

Is there a scenario where we are also always in the black?

The answer is no. In the example I gave above, even if we did place a stop to unwind the position before the stock dropped to the break-even point, there is always a chance of a gap opening  that is lower than our break-even price. In the options market, as in all markets, we get paid for taking risks. The smaller the risk, the smaller the payoff. Our profit edge comes from knowing which risks to take. We do this in two ways: first, by correctly identifying quality supply and demand levels that are highly likely to become turning points for the underlying  and “leaning on” them (betting that they will hold and that price will move away from them); and secondly, by recognizing when options are underpriced or overpriced (that is, when they are pricing in more or less price movement than they should). We’ll talk more about this second aspect in future articles.

I hope these answers help to clarify your understanding.

For comments or questions on 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.