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# Am i understanding options correctly?

Discussion in 'Options' started by 1a2b3cppp, Nov 23, 2008.

1. ### 1a2b3cppp

Hi,

I've been investing for years with stocks but I just recently got into options.

Ok so say I'm looking at XOM Dec 08 options. As of the time of typing this post, the call option XOMLP.X with a strike price of 80 traded last at \$3.15.

Question 1:
If I were to buy this contract it would cost me \$315 + commission, right?

Question 2:
In order for me to make money on this long call position, the price of XOM would have to get above \$83.15, right?

Question 3:
Say before Dec 2008 the price of XOM gets to \$100. Owning this contract gives me the right to buy 100 shares of XOM at \$80, and this is called "exercising" my contract, right? So I hear that the way options pricing works, there is never a time in the life of a contract when it is more profitable to exercise the option and buy the stock and then immediately sell the stock, and it's always more profitable just to sell the long call contract to close the position. Is this true?

Question 4:
In the event that XOM goes to \$100 before this contract expires, how much would I be able to sell it for?

\$10,000 (value of 100 shares of XOM @ \$100)
- \$8315 (value of 100 shares @ strike price + premium)
-------------
\$1,685?

Or do I have that wrong?

If that's correct, does that mean the contract would be trading at \$20 then? So my profit would be \$2000 - the \$315 I paid = \$1,685?

Thanks.

2. ### rosy2

Question 1:
yes

Question 2:
No, in order for you to make money the option needs to get above 3.15

Question 3:
you exercise the call if a dividend is coming that is greater Qthan the same strike put

Question 4:
you need to sell it before expiration. but it would sell for stock price - strike for the most part

3. ### 1a2b3cppp

Isn't the only way the option would go above \$3.15 would be if the stock price got above \$83.15?

4. ### rosy2

no. theres a volatility component. the stock coud go down but if theres some news expected in a few days (like FDA trials) that option could go up

5. ### 1a2b3cppp

Last question: if you don't sell before expiration, does it automatically get exercised (if it didn't expire worthless)?

6. ### thegazelle

Yes, options in the money by greater than .01 on expiration Friday are now exercised automatically.

7. ### JJacksET4

No, as mentioned by another reply, the option has more then just intrinsic value right now. There is also a time component.

XOM has around a 60 IV right now, so you can calculate if the IV remains the same what the value of the call would be at different prices. I like the calculator at 888options.com. Just go to Advanced and then Position Simulator in the menus. If XOM went to 80 on Monday, the call would go to about \$500-\$525 according to my calculations. So, XOM doesn't have to go over \$83.15 to make money - it would just have to be there at expiration for you to make money. Of course, you have to sell the option to realize the profits.

Yes, if XOM went to 100 at expiration, the option will trade at 20.00 and your profit would be \$1685 or so.

Remember that if XOM goes to 79.95 by expiration and you never sell to close the position, your loss would be 100% or the \$315.

Just one more quick tip - it's better to look at the bid/ask for prices, not the last price. I know in XOM case it's OK, since it is very liquid and has good spreads, but occasionally you might see something like:
Last 2.50
bid 2.80

In a case like that, the last trade was probably executed before an upswing in the stock and if you wanted to buy now, you are not likely to be able to get it for \$250 - it will cost \$320 or somewhere between \$280 and \$320 at least.

I only mention this because you mentioned in your post that \$3.15 was the last price. Also, of course I'm sure you are aware, but the open price Monday could be a big divergence from the last trade on Fri (just like with stocks). Of course, there's a good chance if XOM doesn't gap up or down the price will be about the same, but you should at least be aware of the possibility it could move quite a bit.

JJacksET4

8. ### 1a2b3cppp

So say you have an option that is profitable. Can you use trailing stops and such on options the same way you would on stocks so that if it starts to go back down, your option position is closed out for profit?

Next question:

How profitable is it to find stocks where you're expecting high volatility and do long straddles (I think that's what it's called... where you buy 1 call option and 1 put option @ the same strike price)?

I seem to be good at picking stocks that are going to move... I'm just not very good at picking the right direction. Is the straddle a solution to this problem of mine?

9. ### JJacksET4

1a2b3cppp,

I think it depends on which brokerage you use. I use optionsXpress, and I am almost certain they allow this, but I never use it. Other brokers may not have it with options.

Personally, I don't like trailing stops on options as you can be stopped out too quickly. I use "mental" stops more, where you tell yourself you will close if the stock hits a certain price (not usually the option itself). For example, you could close the calls if XOM had gone to 80 and now fell back below 76 or whatever. Of course, if you are doing the mental stops you either have to watch the market constantly or take the risk of a big move when you aren't watching. Instead of stopping out on options, I usually prefer to just trade appropriate size positions and try let them run if possible.

Long straddles can be very profitable, but they can be tough to manage. Also, at a time like this, the IV is already high on most stocks, meaning the straddles cost alot of money up front. However, this may be justified as there could be some large moves over the next 2-3 months one way or another as either the market finally tanks completely, or rebounds huge with a Santa Claus rally.

Personally I think straddles can be a great trade, but where they are difficult is if the stock moves quite a bit and then starts to reverse. You can find yourself in a position to either take a small profit, or risk taking a large loss, or having to adjust the straddle.

For example, if a stock is at \$80 and you pay \$1200 for a 4 month straddle for example, and the stock moved to \$90 fairly quickly, the straddle might be worth \$1500, and if you hold and it moves now to \$100 and \$110, you would make good money, but if it reverses back to \$80 and maybe even \$75, now you are looking at losses and the longer you hold the more the time value drains from the options.

Usually if I trade straddles I try to set a specific date where I will close the position no matter what to keep losses down. Of course setting a date and sticking with it can be 2 different things.

You have to understand with straddles that after a decent movement in either direction, it is no longer a neutral trade. For example if you buy the 80 straddle and you hold as the stock moves to \$100, you are now very bullish on the stock as any up move makes the straddle more and more profitable, but a down move will hurt the position, unless the down move is massive (in this case since you would be \$20 in the money on the call, you would need the stock to move to \$60 or less for the straddle to be just as good on the other side!) Of course remember that if the stock went to \$100 you could just sell the call side for the profit and now hold the 80 put free.

Also, with straddles, be very aware of when earnings comes. After earnings, the IV will often fall and if the stock doesn't move enough, the straddle can get hit pretty hard in just one day. Again with the example above if the stock was at \$80 and the straddle with 3 months left was at \$1200 and then earnings came and the stock didn't move at all, it wouldn't be unusual for the straddle to get hit pretty good, maybe to \$800 or so.

If however, you are really good at finding stocks that move a long way and not just up and back down and back up, etc., straddles could be a great thing to try. I would recommend paper or virtual trading a few to get a feel for them first.

JJacksET4

10. ### 1a2b3cppp

Thanks a lot for that reply!

Do you know of an paper trading options simulators? Or do I need to just do it all in Excel (and just assume I'm buying the ask and selling the bid)?

#10     Nov 24, 2008
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