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Lesson 4 - Parts of an Option

by Uncle Bob Williams

We said that Options are like Insurance, and we will keep with that analogy to be consistent.

Options are available on some stocks and some Indexes. Not all stocks have Options, because some stocks lack sufficient trading volume or interest to have Options. Like an Insurance Policy, we need someone willing to sell the Insurance in exchange for the Premium, and we need someone to buy the Insurance - there is no limit to the amount of Insurance that can be bought and sold as long as we have people on both sides of the transaction. The same is true for Options: we need someone willing to sell the Option in exchange for the Premium, and we need someone willing to buy the Option. On stocks like Apple or Google, and on Indexes like the S&P 500 (SPX Index) there are plenty of people willing to buy and sell Options, so we have a healthy Options market.

When there is a lot of demand and buying/selling activity on the Options for a specific stock or Index, we call that 'Liquidity'. It is good to have liquidity when we trade Options. With more liquidity, the price of the Options is generally lower, and it is easier to buy and sell because a Trade Order will generally be filled quickly.

Here is a typical Option Order:

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BUY 10 | RUT | JULY | 600 | PUT

(Buy 10 Options Contract | RUT [Russell 2000 Index] is the Underlying | July Expiration | 600 Strike | PUT Option)

We will touch on some of the more common terms here. For a more complete glossary, we suggest Options Industry Council Online Glossary:

http://www.888options.com/help/glossary/default.jsp

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Underlying -

The "underlying" is what we are buying or selling an Option on. For example, if we buy a PUT Option on Google, the 'underlying' is Google.

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Options Chain

Here is a typical Options chain, this is on GOOG (which are the Options on Google Stock) from http://Finance.Yahoo.com.



We can see Real Time Options pricing in our Brokerage account, and some Options tools like ThinkOrSwim.com allow us to select what columns we want to see, for example we may want to see some of the Greeks or the Implied Volatility. (We will explain the meaning of those terms shortly.)

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PUTs & CALLs



A PUT, as we mentioned before, is like Insurance. We will make money if the price of the underlying goes below the Strike of our PUT.

A CALL Option makes money if the price of the stock goes UP. It works the same way as a PUT Option, but in the other direction.

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Expiration



The expiration is the date when the Option will expire. The expiration date for all listed stock options in the U.S. is the third Friday of the expiration month (except when it falls on a holiday, in which case it is on Thursday).

The value of the Option at expiration will depend on whether the Option was "IN THE MONEY" or "OUT OF THE MONEY". We will explain the meaning of this next.

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Strike



The Strike is the price of the Underlying where we buy or sell our Option. In the CALL example above, we bought a CALL Option at the $52 strike. We can buy or sell a CALL or PUT Option at any strike that is available. The amount of available strikes will depend on:

=> Demand for the underlying, IE: more popular stocks or Indexes will have more strikes on which to trade Options.

=> How close it is to Expiration. The month of Expiration, for example, may have more strikes available because there will be more Options trading activity.

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Options Symbol



Each Option has a specific symbol, as this is how the Option Exchanges identify the specific Options.

The Options Symbols changed in February 2010 to the new version we see here which provide more information than the older versions.

The symbols are created by using this format:

The basic parts of new option symbol are: Root symbol + Expiration Year(yy)+ Expiration Month(mm)+ Expiration Day(dd) + Call/Put Indicator (C or P) + Strike price

In the top Symbol from the example above: GOOG110618C00290000

GOOG | 11 | 06 | 18 | C | 00290000 (290.00 strike)

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Price



We will look at the prices for the Options which are closer to the current price so that the numbers will be more meaningful. In this case we will look at the 510 CALL strike: (GOOG market price was $ 509.05 when these screen shots were taken)

We can see below that the 500 strike is highlighted in YELLOW, which means it is IN THE MONEY.

We can also see the big price difference between the 500 Strike ($11.80) and the 510 Strike ($5.10). The reason the 500 strike is so much more expensive is because it is $9.05 IN THE MONEY:

$11.80 (Option market price)

MINUS

$9.05 (Intrinsic Option Value: amount IN THE MONEY)

EQUALS

= $2.75 (Time Value of this Option)

The 510 Strike ($5.10) on the other hand is OUT OF THE MONEY, so there is no Intrinsic Value, and the $5.10 price of the Option is all TIME VALUE.

 

Look at the 510.00 strike highlighted above:

=> Last = Last price for this Option PER SHARE.
This shows the last price that someone paid for the 510 Strike Option is $5.10 per share.

IMPORTANT NOTE: Options trade in CONTRACTS of 100 Shares per Contract. (1 Contract = 100 Shares)
If we want to buy 1 CALL Option Contract on the 510 Strike, it will cost us:
$5.10 per share X 100 shares = $510.00 PER CONTRACT

=> Chg = Price change since last trade.
Advanced: The market was closed when this screen shot was taken, and the price of GOOG dropped in After Market trading, so there was a big drop in the Options prices on the Strikes NEAR THE MONEY (Near The Money means near the current price of the underlying).

=> Bid = This is the Market Price if we want to SELL an Option on the 510 Strike.
In this case, the Market Price is $4.80 PER SHARE. (100 shares = $480.00 PER OPTION CONTRACT)

=> Ask = This is the Market Price if we want to BUY an Option on the 510 Strike.
In this case, the Market Price is $5.20 PER SHARE. (100 shares = $520.00 PER OPTION CONTRACT)

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Bid/Ask Spread

"Hey! Why is there such a big difference in price between the selling price and the buying price?!"

The difference between the "Bid" (selling price) and the "Ask" (buying price) is called "The Spread" or "Bid/Ask Spread".

The "Market Makers" are the guys who will fill our orders, and they have to make a profit. Market Makers also take on risk: they are taking the exact opposite position of what everyone else thinks is a good trade. Therefore, there is a price difference between the 'buy' and the 'sell' price. The spread also provides a small buffer for the Market Makers against small price movements of the Underlying so they won't get stuck losing money if it takes them time to unload what they just bought / sold from us.

The amount of "Bid/Ask Spread" can vary greatly, and it's important to keep these differences in mind when making trades.

=> The amount of Options trading activity can affect the "Bid/Ask Spread". Generally, Options that have more trading activity will have narrow spreads; narrow means that the price difference between the Bid and the Ask will be smaller. In plain terms, it means we get a better deal when we trade Options that have narrow "Bid/Ask Spreads".

=> The number of Exchanges that an Option trades on can affect the "Bid/Ask Spread".
The SPX (S&P 500 Index Options) only trade on ONE Exchange: the CBOE Exchange (Chicago Board of Options Exchange http://www.CBOE.com) and so the "Bid/Ask Spread" on the SPX tend to be really wide—meaning we will pay more, even though the SPX is one of the most popular Underlyings for Options trades.
When Options are traded on multiple exchanges like the RUT (Russell 2000 Index), it creates competition between Market Makers on the different exchanges and so the "Bid/Ask Spread" will generally be narrower, and we get better pricing.

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Don't Pay Full Price

IMPORTANT: We do not have to take the "bid” or “ask” price. We can negotiate how much we are willing to buy or sell for, and that negotiation is a critical part of Options trading. The price negotiation can make a big difference in how much profit we make.

It's easy to negotiate, and doesn't require any special tools or knowledge. We simply make an Options order and wait to see if it is accepted.

Let's use the Google 510 CALL Option from the pricing example above:



"Bid" (selling price) = $4.80

"Ask" (buying price) = $5.20

We negotiate by placing an Options order and seeing if it gets filled / Executed. Executed means that they accept our offer and our trade gets filled.

In this case, we want to buy:

BUY 1 | GOOG | JUNE 11 | 510 | CALL

(Buy 1 Options Contract | Google is the Underlying | June 2011 Expiration | 510 Strike | CALL Option)

Version 1: Pay Full Price
We could be willing to pay full price for this Option, and the current "Ask" (buying price) is $5.20 per share. We can place a "Market Order" for 1 contract, and we will pay the market price of $5.20 per share. (We will explain "Market Orders" later in greater detail.)
In this case, the 1 Contract will cost us $520, plus the trading fee from our Broker. ($5.20 per share * 100 shares = $520. Remember that 1 Options Contract = 100 shares)

Version 2: Cheapest Price Possible
We could insist on getting the best price possible, and could offer to pay only $4.80 per share (which is the 'selling' market price). It's always possible, but not likely, that this order will be filled. If the Market Maker fills this order, it means he won't make any profit on the trade, which they are not likely to do. It doesn't cost us anything to place the order, so we may decide it's not worth it to pay any more than that amount, so we can make the order and just wait. It is possible that the price of the underlying changes and the price of this Option goes down, and the Market Maker will fill our order when he is going to make profit. If however, the price of this Option does not change, it is unlikely that our order will get filled and we just wasted our time.
(When we specify a specific price we are willing to pay for an Option it is called a "Limit Order" and we will discuss these in more detail later.)

Since we don't want to pay full price, and we don't want to waste our time, we want to make an offer to buy somewhere between the Bid and the Ask.

If we have a lot of time, we can start at the lowest price and wait to see if our order is filled. If our order is not filled, we can cancel that order, change the price by the smallest amount possible (some Options contracts trade in 1 penny price increments, some in 5 cent increments, some in 10 cent, etc.). We can keep doing that until our order gets filled.

At Uncle Bob's Money, we usually trade multiple Options at the same time, which are called spreads. A "vertical spread", otherwise known as a Condor, could be:

Sell a Call (Bid: $1.20, Ask: $1.30)

Buy a Call (Bid: $0.50, Ask: $0.60)

By combining the Best price of each, where we get the maximum amount on the position we sell: $1.30, and the cheapest price on the position we buy $0.50, the NET Maximum best price is $0.80 Credit. We could place our first order for this 'spread' as a $0.80 credit and then slowly go through the process of increasing our price until our spread gets filled.

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Volume



The Trade Volume is the amount of contracts traded on this Option.

If the volume is low, it means the liquidity is low and your ability to negotiate price will be low.

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Open Interest



The Open Interest is the amount of outstanding Options contracts for this strike. Open Interest is used as a liquidity gauge. It is best to trade on Option Strikes that have a lot of Open Interest, because it means there will be more liquidity and more opportunity to negotiate a better price.

NOTE: It is important to pay attention to the amount of Open Interest on each leg of the spread we want to trade on. It is possible that one of the legs has very little activity which can happen. As the Options get closer to Expiration, more Options Strikes will become available. If one of our Option positions is in a spread with very little Open Interest, we won't be able to negotiate the price too much. It is always better to pick strikes with a lot of Open Interest so we have the most activity and likelihood of getting a good price.

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