General Topics
Markets
Technical Topics
Brokerage Firms
Company Specific
Community Lounge
Site Support

Discussion in 'Options' started by JForex78, Sep 12, 2019.

1. ### JForex78

Hi,

I am new to this forum. And to Options trading.

I have read a lot before posting here. And based on that, have come up with some use cases I can execute.

But I am looking for confirmation of my understanding.

Can you help me with these below?

Thank you.

PS - I use only Buy side for discussion, I understand it applies to Sell also.

1. Is it correct that out-of-the-money Options are always cheaper?
I always see them under \$2 - like \$1.5 to cents.

Because anyone can buy at the market for lower price.
Can this be taken as a general statement?

2. Is it correct that after the option becomes in-the-money, its price goes up by almost same price as stock?

For a stock is trading at \$50, I buy a Call@\$50 for \$1.
If the stock goes up by +\$10 to \$60 - the Call price will also go up by almost +\$10 to \$11?

Minus some difference.

3. If 1 & 2 are true, I made a Use Case of how I can use a Call to Leverage my Buy.

Assume a Stock is trading at \$50. I buy a Call Option at \$55.

Because it is \$5 out of the money - I can hope to buy the Call@55 for \$1.

If stock does not go up, or only goes up to \$55, I just let it expire at its new lower value. And lose a max of \$100.

If stock does goes up by +\$15 to \$65, the option will also go up by +\$15, making it \$1+\$15 = \$16.

So I have \$10 gain on \$1. That's 1,000% Gain?

Is this correct?
In what cases can this go wrong?

4. If I hedge a Dividend stock with a Put option, I can keep all Dividend(-premium) with no to minimal risk?

I am going to make up some numbers to make the point.

Stock trading at \$250 pays a dividend of \$5 in the coming week.

First, I buy Put@250 at \$2
Then, I buy the stock at \$250.

Stock pays \$5 dividend.

I sell the stock at \$250 at \$0 loss.

Basically, the dividend is only reduced by the premium.

Is this correct in theory?
Where and how can it go wrong?

5. If 4 is correct, it will work with high price stocks only.
Because at a given yield, we need the dividend/ share as much higher than the premium as possible - to keep most dividend.

\$1 Dividend - \$1 Premium = \$0
But
\$5 Dividend - \$1 Premium - \$4.

Thats keeping 80% of the dividend.

Thank you.

Last edited: Sep 12, 2019
2. ### El OchoCinco

Get a good book on options so you understand the basics.

If you really wanted to learn about options, wouldn't you put the effort in to research and learn? Your questions encompass so many fundamentals you do not know and you will not understand the answers. Look for any basic introduction book on options and read and read and almost all of the above questions will be answered.

3. ### JForex78

I read a lot before posting here.

And built my cases above are from that reading.

I am looking for confirmation.

If you cannot help do that, pls let me hear from others.

4. ### gaussian

You can't just consider buy side. You need to understand sell side as well.

(1) Yes, in general deep OTM options are cheaper.

(2) No. An ATM option has a delta of around 50. A deep ITM has a delta closer to 100, which would move in lock-step with the underlying.

(3) You're mostly correct in that buying an OTM call will resulting in an outsized gain if the stock moves that far.

You didnt mention the volatility of the underlying but that matters as well. If the IV of the option you have is high, and the stock jerks higher like you want, but the IV plummets (called "IV crush") you can still lose money. You would have to go DEEP in the money to get a delta closer to 100 to get the desired effect.

(4) No. A dividend will decrease the value of a stock, increasing the value of a put. If you are short the put against your holdings you will get the dividend and the put will lose value in time with it. If you are long a put the value of your put will go up as the stock price drops. Assuming IV isn't expensive you will get to keep your dividend less the premium paid on the put.

JForex78 and MACD like this.
5. ### El OchoCinco

The way you phrased the questions shows a lack of understating how options work.

For example in #3
"If stock does not go up, or only goes up to \$55, I just let it expire at its new lower value. And lose a max of \$100"

If the stock goes up or volatility increases and there is still time to expiration the option can increase in value. Why would you not sell for a profit at that time? Why would you let it just expire and lose the max value? Do you know options move up and down in price with not only intrinsic value but time value premium as well? If the stock goes up to \$55 before expiration your \$1 option could be worth \$2 depending on time value premium, why let it expire worthless then?

these are basic questions that get to the heart of option pricing, the greeks and how options are priced.

With all due respect, you don't need confirmation of misinformation, you need more fundamental study.

6. ### El OchoCinco

Also asking in what cases can this go wrong is also part of the fundamental knowledge of option pricing and the Greeks.

What are your risk factors? Well delta, time to expiration, and volatility.

If you buy a \$55 Call with the stock at \$50 your assumption is the stock making a 30% jump to \$65. If this was realistic the IV of these options would be extremely high and the OTM call would not be trading for \$1.

I know this is a hypothetical but using these kind of numbers hints at a lack of understanding.

In theory what you said is true. If you buy the \$55 Call for \$1 and the stock is at \$65 at expiration your call will be worth exactly \$10 at expiration and your profit is \$9. It will be worth its exact intrinsic value. Anytime before actual expiration it will be worth intrinsic + time value premium.

JForex78 likes this.
7. ### JForex78

Selling the option at 55 is a possibility. But I dont want to sell the option because I am hoping the stock would go even higher.

I am trying to make the point that if it goes even higher, the gain can be huge due to leverage.

Yes, thats what I am trying to establish for myself.

Last edited: Sep 12, 2019
8. ### JForex78

The value of the Put, or the share may change any way it likes.

I am going to exercise the put to sell the shares at the Strike price close to where I bought the stock.

The way I am seeing it, change in price of the Put or the Stock is out of the equation

Is that right?

9. ### El OchoCinco

Options are leverage so your relative gains are bigger using derivatives versus a move in the underlying. Not wanting to sell the option because you always think it will go higher is often why newbies sometimes see options expire worthless when they were holding on to a profitable position. Just be careful thinking the run is unlimited. We use options as tools to generate returns, not to lever for constant home runs.

As I said most books cover option pricing and intrinsic v. time value premium. the only time you will know exactly (so to speak) what an option will be worth is at expiration when time value premium is zero and the option has to be worth intrinsic or \$0.

JForex78 likes this.
10. ### gaussian

It's actually not as hypothetical as you let on (except the OTM being \$1, yeah thats not right). Earnings plays come in mind where a novice will buy a deep OTM option hoping for a miracle but get crushed when IV takes the floor out from underneath them.

Remember you do not own a dividend by just owning the option and you must exercise to get the dividend. This example is not correct - this is what would actually happen:

1. You hold a long put against your underlying
2. The underlying drops below the strike