Confused about Option value.

Discussion in 'Options' started by themadride, Oct 18, 2008.

  1. Hey there.
    I'm pretty new to the options trading game. I get the underlining idea and have had pretty decent luck with my first few options adventures, but I have a newbie question about the value of an option in relationship to the increasing value of the stock.
    This evening I was looking at McDonalds (MCD) for some November Calls. The stock is trading at 53.80 at the close.
    The Nov 50 Strike (In the money) last sold at $6.50
    The Nov 55 Strike (OTM) last sold at $3.50

    My confusion is that 53.80 (stock value) minus 50.00 comes to $3.80. If you subtract $3.80 from the premium of $6.50 it comes to $2.70. So, $2.70 is priced into the premium BELOW(or before) it was In the money.
    On the other hand, the Nov 55 strike is not even in the money and has $3.50 priced into the premium.
    I'm confused. With two calls with the same expiration date, it would seem that the contract IN THE MONEY would be the one worth proportionatley more.
    The basic thing I'm trying to figure out is that when I'm being completely bullish and just buying strait calls....where should I choose my strike price. I'm having trouble figuring out why I should select a strike price that is close to being At the Money? Why not just select cheaper contracts further away from the money if they are going to raise in value faster?

    I hope some of that made sense. I'm still waiting on my Options Trading books to come from Amazon:) So, trying to figure some of this out now to take advantage of this market.
    Thanks in advance!
  2. As the option moves further in the money (ITM), there is proportionally more intrinsic value, and less volatility-derived time (theta) value.

    You see this reflected in the option's delta. Very deep ITM options have deltas approaching 1. That is, they move close to 1-to-1 with the stock and are much less affected by volatility pops and drops.

    As for methodology there are many many MANY ways to play the whole game. Here is my theory. I'm sure others have much better ideas, but here ya go:

    1. If you are short-term trading, hours to a few days, you are probably better off just trading the stock. You get 4 X margin anyway (day margin) and, usually, far better b/a spreads. Spreads on even liquid ops are mostly horrible and can really suck up profits.

    2. If you are really bullish (or bearish) you can buy deep ITM calls (puts) with the mind set that they are nearly stock substitutes. You get low time value to pay for and a delta nearing 0.9 or so, for about 1/5 to 1/4 the cost of the stock. The rub is, there may be fewer strikes and less open interest and liquidity.

    3. You MUST have reasonable profit targets and stop loss points. And never over lever. Don't do more options than you would have done with just the stock, or you will eventually be very sorry.

    4. You'll probably be sorry you started trading options anyway. If you can't make money trading just stocks, you are likely to fail trading options. For most people, IMHO options are better vehicles as adjuncts and add-ons to stock trades.

    5. If you want a high probability of blowout and failure, trade stocks and futures short-term. If you REALLY want to blowout, trade options!

    Good luck and keep coming back here with trade ideas and suggestions. There are plenty of people that can help. Much more than me, I hope. :cool:
  3. Tums


    no need for beginners books... there are lots of FREE tutorials from websites, brokers sites, option institute... etc.,
  4. spindr0


    Though it's not significant in this example, closing quotes can be misleading (particicularly with illiquid options) since the last trade for the option may have occurred long before the close and as a result, the pricing relationships may be off.

    You select the strike based on the amount of the move that you expect. ITM calls make money immediately versus less from the OTM call (see the DELTA of the option). OTOH, OTM calls make a larger per cent gain if the move is greater. They provide leverage.

    As a simple example, you can use the option chains to get a feel for this. Consider an immediate 5 point up move with no change in IV. If you bot the aforementioned Nov 50c for $6.50, it would be worth $10.20 (the avg B/A value of the Nov 45c) for a gain of $3.70 (57%). The Nov 55c bot for $3.50 would be worth $6.50 for a gain of $3.00 (86%). But beware, leverage is a double edged sword and is as bad to the downside as it is good to the upside.
  5. Scott,

    1) NEVER look at the last trade. Only consider the current bid/ask market. You can use the midpoint of that market as a reasonable price.

    The 'last' can be hours old. Or perhaps one option traded at the ask price and another at the bid price. You learn nothing by comparing those 'last' trades.

    2) I'm sure you know that you cannot depend on luck.

    3) Option values are not based on ratio, so one is not worth 'proportionally' more than another.

    4) Cheaper contracts that are further out of the money have a smaller chance of being worth much as time passes. And time is the enemy. If you buy MCD 65 calls, and the stock slowly marches higher, you lose it all when MCD is anywhere near 60 at expiration. Do you want to see your stock climb 10% and lose everything?

    Probably not.

    Two points:

    a) Do not plan on holding all the way to the end. Plan on selling and recovering some of the time value you paid.

    b) If you don't have a target for how high the stock is going to move (or more importantly, when it will move), you cannot afford to buy options that are out of the money. OK, you can buy 55s when stock is 54, but don't be buying 60's without being willing to bet that the stock is going to make a big move.

    Please believe this: It is very difficult to make money over the long term when you buy options. That does not mean you should simply sell options.

    It pays to <i>understand</i> how options work before you put too much real money on the line.

  6. mike007


    You option values are determined by many different factors. Time to expiration (Theta), Volatility, and they Theoretical Value of the option for the price of the stock that it is trading under.
  7. ==================
    Scott-T Trader;
    Options can work your brain;
    but dont over figure it:cool:

    Answer -Out of money[otm] options;
    can increase % much better, but the increased leverage can go against you much more/faster, when wrong .

    You may make money on those calls;
    but the trade seems rather low propbibility-
    a]its a bear market[SPY,DIA,QQQQ.............,]
    b] MCD is in a bear market also,
    c]buy volume looks weak,
    f]also you may notice in bear markets ''suprises '' tend to reoinforce the downtrend.

    MCD could easily go to 10 or 20 bucks;
    otm calls in that case ,would lose your capital faster than almost anything.

    Wisdom is profitable to direct

  8. Thanks everyone for the help. I understand better now the greater leverage existing the further out of the money you go.

    As for general options trading. I'm doing it on the super short term(if possitive obviously) I usually trade in and out of Otm calls the same day just trying to take some modest gains. If they the stock is dropping for what I believe is a short time, then I scale into the option the same as I would a stock. If I think it going down for a long time...I just dump it quick and get short. I haven't experienced that final scenario yet though, so that's just the plan.

    Thanks again.
  9. spindr0


    If you're trading intraday, consider trading the underlying rather than the options. As Wayne mentioned, you deal with far better B/A spreads... and you don't have the problem of a lower DELTA.

    IOW, if you buy an ATM option, it's delta is about .50 so you're going to make 50 cts on a $1 move in your direction less the B/A slippage. That could mean 30-40% of the move. Not good. With a liquid stock, you only need 30-40 cts to achieve the same.

    I used to trade a lot of options and now I primarily trade the stocks. About the only time I venture into options is for more complex strategies for option plays, attemting to take advantage of near month IV expansion and crash.

    Trade what works for you. My two cents is that long options intraday is a lot of work for a lot less profit.
  10. Thanks for all your help. I really appreciate it, and I am not trying to be contrary, but I'm not sure I understand how owning the underlying stock would be more profitable. I'm going to illustrate with an example.

    On Thursday I bought Nov calls on Family Dollar Stores (FDO) with a strike price of $25.

    I bought 4 contracts @ $2.20 each. TOTAL: $880
    - The regular stock was trading at $23.85 at that time.

    I sold the contracts @ $2.75 each. TOTAL: $1100
    - The regular stock was trading at $25.50 at the time.

    Subtract the fees of $15.10 for a total gain of $204.90

    *** If I had spend the same money on the underlying $880 would have bought 36 shares for a total of $858.60
    Selling the 35 shares would have brought me a total of $918.00
    Subtract the fees of $9.90 for that fictional trade and the total gain would be $49.50

    I understand that the risk is greater with options...which makes them perhaps less profitable in the long term...or in theory somehow, but I don't understand your exact point.

    Unless I misunderstood you, it seemed like you were saying that making the same trade with the assets will be more profitable than with options.
    Please expand a little on this if you can. Thanks very much.
    #10     Oct 18, 2008