ET News & Sponsor Info
General Topics
Technical Topics
Brokerage Firms
Tools of the Trade
Trading for a Living
Community Lounge
Site Support

beginner question

Discussion in 'Options' started by bufferman, Feb 6, 2004.

1. bufferman

Hi:

I have a very basic question that I am confused about. I was reading beginner's material on options and it says:

For example, you buy a \$50 option for \$5, then the stock will have to move to \$55 for you to break even.

This doesn't make sense to me bcuz say I paid \$5 for an option of 100 stocks trading at \$50, if I sell that same option at the same \$50 strike price, wouldn't I get my \$5 back?

I would appreciate if someone can clarify.

thanks,
Paul

2. weewilly

An option is a wasting asset whose value decays finally to max(0,stock price-strike price), in the case of calls. If you paid \$5 for a 50 strike call on a stock trading at 48, the option is out of the money and the stock must rise above 55 by expiration in order for your option to be worth more than what you paid for it. If the stock goes to 60, the option is worth 10 at expiration, so you doubled your money. If the stock stays below 50, you lose your entire investment.

Options are actively traded, however, so a \$5 call may in fact be 4.95 bid 5.00 ask, meaning you could buy it now for 5 and sell it immediately for 4.95, for a nickel loss. As each day goes by and you approach expiration, the option will be worth less and less, i.e. tomorrow the option may be 4.90bid 4.95ask.

cheers.

wee

3. bufferman

Thank you for the clarification, so in the end I could at least get most of my \$5 back, even if I sell it after a couple days if the stock is trading at the same price?

Say in general, and I don't know how this works in real trading but I am only guessing here:

1st Day: A \$50 Call for a stock trading at \$48 is \$5

2nd Day: If the stock is still trading at \$48, the call is now \$4.90 and I can still sell my option to get this \$4.90

Alternate 2nd Day: The stock is now trading at \$49, so I am guessing in this situation considering the 10 cent time decay, but since the stock is moving toward the strike price, would the option be worth more? Perhaps \$5.80 ?

Btw, just to clarify another aspect. That \$5 I paid wasn't the broker commission right? That's separate?

4. weewilly

Thank you for the clarification, so in the end I could at least get most of my \$5 back, even if I sell it after a couple days if the stock is trading at the same price?

Yes, but note that the option wastes away faster as expiration approaches, not linearly throughout its lifetime. With about two weeks of life left, you'll observe out of the money options start to lose value faster each day.

Say in general, and I don't know how this works in real trading but I am only guessing here:

1st Day: A \$50 Call for a stock trading at \$48 is \$5

2nd Day: If the stock is still trading at \$48, the call is now \$4.90 and I can still sell my option to get this \$4.90

Alternate 2nd Day: The stock is now trading at \$49, so I am guessing in this situation considering the 10 cent time decay, but since the stock is moving toward the strike price, would the option be worth more? Perhaps \$5.80 ?

Options whose underlying stock price is at or near the strike are called at-the-money. Their value moves about .5 pt for each point move in the stock. Your 50 call may go from 5 to perhaps 5.35 or 5.40 on a move from 48 to 49. Very approximately. It almost surely won't gain .80 cents however. As the stock moves above 50, the option will get closer and closer to gaining value exactly with the stock.

Btw, just to clarify another aspect. That \$5 I paid wasn't the broker commission right? That's separate?

Correct. the \$5 is the "time value" of the option. An options price is comprised of time value and intrinsic value. Out of the money options have no intrinsic value. As the stock moves above the strike price, the option's intrinsic value is that portion of its price equal to the stock price- the strike price. That \$5 call may be worth 7 bucks if the stock rises to 53 with lots of time left: 3 bucks "intrinsic value" and 4 bucks in "time value".

wee

5. bufferman

Ok this is from the stuff I am reading:

---------------------------------------------------------------------------------
I actually witnessed this trade at a brokerage firm. A trader was long 20 calls at \$4. In his mind, the most he could lose was \$8,000, which was the total paid for the contracts.
--------------------------------------------------------------------------------

Why would he pay \$8000 for 20 contracts?
According to this, one option cost him \$400?

The course assumes that each option is of 100 shares.

I know this doesn't seem like enough information and this is a confusing course, but even if the stock was trading at 0.10 and he bought the calls at \$4 strike price, why would he pay \$400 for one option contract? I thought it was a much less amount, of course I don't know how to calculate that yet.

thanks again,
Paul

6. weewilly

Options prices are quoted per share, not per contract. The standard contract is for 100 shares which is 1 round lot of shares. One option contract quoted at \$4 ask will indeed cost \$400 plus commissions to purchase. 20 of them will cost \$8,000 plus comms.

wee

7. bufferman

oh dang, my bad.

thanks for the explanation.. I will post futher to this thread if I have more questions. I was so excited before that a 100 share option costs only \$5.. and now

9. wdscott

Bufferman,

Go to your local bookstore and skim over Larry Macmillans option book to see if this is an area you wish to pursue. Options are a complicated asset class, and may not be suitable for you.

As a licensed series 7,3,66 broker I have seen far too many option novices loss their shirts in this game. Some strategies are quite dangerous ie. naked writing.

On the flip side, I have witnessed large gains by option professionals. But, these guy were experts, with many years experience.

Good Luck,
Dave Scott

10. bufferman

Thanks, I am aware of the risk.
The course I am reading on has a lot of details.
I will check out that book as well, and of course I am not getting into options unless I know everything about them.

#10     Feb 6, 2004
WHILE YOU'RE HERE, TAKE A MINUTE TO VISIT SOME OF OUR SPONSORS: