Thats EXACTLY right. When you see a contract for $8.95 thats a per share premium. So to actually buy that contract you need $895.00.
thanks for clearing up IV for me, although im still not exactly sure what a high or low IV looks like. however im wondering is a delta of .1 or .2 bad if you only paid $0.10? wouldnt you be making 100% per dollar the underlying stock went up? or am i misunderstanding delta? for example lets say the price of option abc is $1.00 and it has a $10 strike and a delta of $0.10. the underlying stock rises $5 making the price of abc $1.50. would the price really be $1.50 or does the delta rise as the stock gets closer to its stock price? is the delta calculated by the options past performance? if so is delta a reliable indicator for what the option will be or is it more like a guide? thanks again for the education
I will speak on points 2 and 4. Vix is a measure of volatility based roughly on the sp500. For example VIX hit a historical low during the last bull market, you will see VIX spike over thirty when it looks like the world will end (trading wise). You have to be careful trading options as they are leveraged. Imagine trading 1,000 shares of GOOG. This is a 10 lot in options fairly small trade by even retail standards. You should understand leverage and what it can do to your account. I would suggest getting a demo account and practice executions, strategies, etc. This will cut down on errors when you trade with real money which is easy enough to lose. Read first thirty pages when you get a chance. http://www.elitetrader.com/vb/showthread.php?threadid=53037
In a very rudimentary theory yes the option would then be worth $1.50. However to really understand what will happen to an option you really need to understand all of the Greeks (of which Delta and Theta are the two most important: Delta: This is the amount the options price will move as the underlying price moves UP. The value will always be a number between 1 and -1. A positive value means the option will move up as the underlying moves up and a negative number means the option will go down as the underlying moves up. Theta: Is the measure of time decay. This is the amount the option will lose per day as the option gets closer to expiration. Things that affect Theta include: Time to expiration and how far in or out of the money the option is. Gamma: Is basically the rate of acceleration in Delta. In other words it measures how much the Delta of an option will increase or decrease based on a $1 move in the underlying. Vega: Is the amount the options price will change in theory as the implied volatility changes. The change from Vega only usually applies to the time value of the option which in combination with Theta controls the time value of the option. Ro: This little guy isn't too important but I will mention it for the sake of completeness. Ro is a measure of how much the options value will change based on a 1% change in interest rates. Now back to your question about what would the future price of the option be? It would depend largely on how long the underlying took to reach that $5 move. If it did it in 1 day and the option had a Delta of .1 and a Theta of -.05 then the value of the option the next day would only be $1.25. If the stock took 3 days to move that $5 with a Delta of .1 and a Theta of -.05 then the options value would only be about $0.75. Adding in the effects of Gamma to the 3 day example, the option value might end up anywhere between $0.90 (assuming Gamma of .02) and $1.65 (assuming Gamma of .06).
Thanks for all the great info. Im pretty sure i have a good idea how to determine the hypothetical price of an option now. whew. im still a little confused on implied volatility, i can see them, but im not sure how to tell a "high" volatility from a low one. is there a par volatility for a typical day on wall street? should i look at the VIX index for this as well?
Sign up for a free account at <a href="http://www.ivolatility.com">www.ivolatility.com</a> then look up whatever equity you are planning to trade. This is the volatility of the STOCK. Below is the 1yr volatility chart for RIMM notice that it's average looks to be about 50% and it's current is about 70% so it's fairly high volatility right now. As far as the implied volatility of the option goes once you are looking at the chart for the stock on Ivolatility.com you will see links for the IV Index Calls and Puts directly above the chart. You can also change the time frame if you wish. Use these charts to determine if the IV is on the high side, low side or right at what is normal for the stock and it's options. <img src="http://www.fantasydaytraders.com/eqpics/RIMM-Volatility.jpg">
Oh when looking at these volatility charts don't forget about your greek friend Vega. If the volatility is high you can bet your friend Vega has the option price jacked up a bit. This isn't too big of an issue as long as volatility stays the same or gets higher during your trade assuming you BOUGHT an option. If you buy an option with high volatility and the volatility drops the options value will drop. If the volatility goes up the value will go up. So in general when buying an option you want the volatility to be low to normal and heading up. When shorting an option you want the volatility to be high to normal and heading down. You can't always wait for optimum volatility entry points but it is good to understand how it can affect your trade.