Simple question about options

[thetree]

I am new to options trading and im trying to gain some understanding. I was hoping someone could clarify something for me. I understand a call option as a contract that I buy that allows me to buy the stock at the strike price on or before the expiration date.
Now, I wanted to check this out in real time and went on TD ameritrade to get the option chain for GM. Now, the 2.00 call for 5/16 is at .30 (+GMEW). The stock is currently trading around 1.85.
The way I understand it, it will cost me 30.00 for 1 contract. So this is really making a bid that the stock will get above 2.30, right? I dont see why I would want to spend 230 for 200 dollars worth of stock. This option is betting on a better than 25 percent gain in a month.

I think I have this correct, just wanted to double check.

[terrymr]

I am new to options trading and im trying to gain some understanding. I was hoping someone could clarify something for me. I understand a call option as a contract that I buy that allows me to buy the stock at the strike price on or before the expiration date.
Now, I wanted to check this out in real time and went on TD ameritrade to get the option chain for GM. Now, the 2.00 call for 5/16 is at .30 (+GMEW). The stock is currently trading around 1.85.
The way I understand it, it will cost me 30.00 for 1 contract. So this is really making a bid that the stock will get above 2.30, right? I dont see why I would want to spend 230 for 200 dollars worth of stock. This option is betting on a better than 25 percent gain in a month.

I think I have this correct, just wanted to double check.

Right, you're probably looking at $30+commission+(possibly a $1 per contract fee). So if your regular commission is $10 ... you need the stock to be over $2.41 to make money.

You can also hope that the stock makes a quick run past $2 and you can sell the contract for a profit.

[thetree]

You can also hope that the stock makes a quick run past $2 and you can sell the contract for a profit.

But won't everyone else be looking at the same numbers we just figured out and see that it is still worthless at 2.00? Or are you saying it has to happen quickly with lots of life left in the contract so I can sell it with "room to move"?

[terrymr]

But won't everyone else be looking at the same numbers we just figured out and see that it is still worthless at 2.00? Or are you saying it has to happen quickly with lots of life left in the contract so I can sell it with "room to move"?

Right - the price of the contract would generally be higher with more time left on it.

There's a ton of reading material out there on the internet, but you have a basic grasp of it.

[Dr. Dave]

Hi -

I could write a page easy answering your question - but I'm in the middle of moving, so I may get back to it later.

In your case - there are two things to do if you were to have bought the contract:


1) exercise it - ie. buy the 100 shares at $2.00 and sell it at the market price - on expiration date or earlier.

Here, if after you buy the contract, if the price were to skyrocket to $4.00 anytime in between the time you bought it and the expiration date, for example, lets say a week before, you can buy 100 shares at $2.00 = $200. Then you could sell them that day for $400, making a $200 profit - minus the price of the contract, so $170, and the transaction fees - again, using $10 as an example $160 would be your profit over all. Or you can hold it a little while longer if you still think there is upward movement left - ie. to $5.00 a share. In that case, the selling price of the shares would be $500 and you would make $460. You aren't targeting the strike price in this scenario, but something higher to where it's profitable.

The trouble with 1 contract at $0.30 is the commissions. It would be better off to buy 10 contracts. So in the example, you'd plop down $300 to get the right to buy $1000 shares at $2.00 per share. When it hits $4.00, you exercise, sell for $4000. Making $2000 - $300 (contract) = $1700 - $10 = $1690.

If you think it's going to hit $2.00 at the max, you should be looking at something like a contract to buy at $1.00 or something along those lines.

Now if the price never exceeds $2.00, or in your case, as stated $2.40 (I think that's right - then its basically a wash, and thus anything below that, you would do nothing, and thus either sell your 1 contract before hand if you think you made a mistake, say at $0.15, to only take a 50% loss. Now that's where just the 1 contract at $0.30 and the commissions comes into play. Here, now, the value of the transaction would be $15 - (commission 2 x $10) = -$5... so it's not even worth it. But say you had gone the 10 contract route - you'd still get $150 with the 50% loss - and then with the 2 x $10 commissions have $130 left. Which isn't quite so bad.

Most go into it with the idea of a stop loss on their contract of 50%, or all the way 100% - in the example, the price never hits $2 so at expiration day, you lose the $30 and of course, it's $40 really, when you consider the one commission.

2) Going in with the intention of selling the contract. Let's say you think there's some upward momentum up to and past the $2.00 mark up to $4.00. Contract price today when the stock is $0.50 a share is $0.30. Great earnings come out tomorrow, and the price shoots up to $1.00 share. I see that, and think its going to spike even higher to $5.00 in the next few days - Since the price shot up, lets say you have the lowest asking price now at $0.40 even, as now you are super enthusiastic that it can get even higher, but you don't wan't to tie up your $200 for the actual exercise cause you want to buy SIRI tomorrow, and you sell to me. Now you just made (in terms of percentage) a great profit (not in terms of dollars though, cause you bought only 1 cheap contract). So your profit is $10 overall, but again it will cost you $20 in fees.

If you had bought 10 contracts though, costing $300, then sold to me for $400, you just made $100, then subtracting fee's walk with $80.

Now again, if the price doesn't look like its going to exceed $2.00 and it never does during the period before options expiration, your contract will be worth $0 on that day. But again, you could sell the contract at say a 50% loss at $0.15 - of course if its 1 contract, its not worth your time, but if it were $10, then you can recoup a little of that contract fee.


####
Now that's the simple side. We haven't even delved into how premium works - there is a time decay factor. 1 or 2 months out, there is plenty of room for the stock to get from say $0.50 to beyond $2.00, so the contracts are more expensive - at 4 pm on the third friday of the month, when they expire, the contracts are (or should be - I've never exercised an option) - at their intrinsic value - when exercised represent the stock price - or at least the ones at the strike.

This is what screws with most beginners and how they lose their money. Let's say that you bought your $0.30 contract on monday. For whatever reason, the stock price on tuesday is $1.00. Let's say the premium (I'm not going to take the time to calculate what's realistic - which I didn't in the above scenarios either - but you can still see how it works) is still $0.30. Then wednesday, the stock price is still $1.00, but now the contract is worth $0.27. On thursday, the stock price, when you look at it, is still $1.00, but now the contract is $0.25. That's because, there is now less time for the price to shoot past $2.00.

Now it's not just the time that's involved - there is also the volatility.... lets say tuesday the stock rose from $0.99 to $1.00 and your contract went from $0.30 to 0.31 at the end of the day. So in this case the new buyers don't have a lot of faith in the move past $2.00 for the stock price. But lets say on the same tuesday (if we waited for wednesday for this example, we'd have to take into account time decay) the price had been steady for weeks at $0.50 a share, but this tuesday skyrocketed to $1.00. The contract now may have gone from $0.30 to $.60, because some folks are thinking its going thru the moon - at least at the end of that day. So you can see that even on the same day, at the exact same time, that even if the stock were $1.00 - the contracts may trade at different prices due to the momentum of the stock price movements.

In essence, not only do you have to be good at setting price targets - you have to be good at timing them and reading into momentum and knowing what the premium value decay will be as the expiration date moves closer and closer. With stocks - you don't have to worry about the momentum or the date they get to a price to profit - just only what your tolerance is to how long you have to hold it. Some guys betting on SIRI have been and may still be waiting to break even or profit, but don't have to do it by a certain date or see a certain bit of momentum before they lose 100% of their investment.

One other note - to exercise an option, you do have to have the money in your account to buy the shares on expiration and your brokerage will warn you in advance of that. So if you can't buy $2000 worth of shares, then you shouldn't plan on buying 10 of those $0.30 contracts. You can buy the contracts without the money of course ahead of time, you just have to come up with the funds to exercise them. That's how some people leverage money - they buy contracts for more than they could afford to buy in stock price, but sell the contracts before they expire, or take the loss on their premium.

I guess, I could have sent you to this:
http://en.wikipedia.org/wiki/Call_option

Bottom line - you should be very good at trading or willing to take a string of 100% losses when dealing with options - some just use it to hedge their trades, while others use it to make a lot of money, while risking less per say - especially when markets are headed down and dealing with the choice of selling short or buying puts.

The time to buy or sell stocks, and buy or sell contracts really depends on the market movement and your stock.

ie. I just shorted AAPL the day after their earnings release - I think its heading down. But its only gone down one day, and I have a stop loss just above the high - I'm not out much if it reverses. And MSFT came in ok - shot up, but its at resistance - bringing the tech market up with it. Shorting is the better option here for me, as MSFT is going to influence AAPL and it may take a little while to get momentum to the downside. If that occurs.

Every day, I would be losing contract premium if had started my option trade on that day, when MSFT had yet to report the following day. MSFT's results could have even changed the options price of the AAPL contracts. It will take a few days to see where the two are truly heading. So with a short, I can get out without much of a loss. The momentum isn't yet there (or I personally don't see how I could choose that day, since its too early in the game) with the options to make a play on puts. Now if I'm right and as more and more stocks hit their 200 SMA's. There could be some volatility. So a few days from now, the options contracts, that have also fluctuate much greater than the stock price [trust me, seeing your options contracts swing 80% in one direction or the other over a one day period is common], may be a good way to make money, where as, shorting I would have started too far from my stop loss by the time I knew the momentum is coming - as prices zig and zag.

I'm a beginner in options myself, so do a lot of research on them before you trade, and be ready to pay that tuition. I hope I didn't make any mistakes above, but could have, busy day. Unless you plan to do some minor hedging, I'd even recommend trading thru a service at first, and let them pick a few that you believe in based on your knowledge of the sector and TA.

All in all, I just wanted to explain that it's complicated.

[thetree]

Thanks,
It seems like everything you said strengthened the basic knowledge I have already gathered. I appreciate the examples you gave. I have been trying to decide whether buying In the money or out of the money was the better way to go and your examples gave me more food for thought.

I am a TD ameritrade customer. I wanted to buy some cheap "long shot" call options. I applied for an options trading "upgrade" which they rank in "levels". "Level 2" options trading allows you to buy calls only. I was denied. I cannot understand why. I can understand denying someone to buy PUT options or short selling because the risk is infinite. I dont know if they are on the hook for it if you cant cover the losses, but i could understand if i was requesting that. There is no risk in call options past buying the contract. Are they trying to protect me from my 100% loss if the contract doesnt meet the strike price?

Why would I have been denied for buying call options?
In the application I answered that I had "limited" investment knowledge, that I have been trading for less than one year, and entered my net worth, less than 50k. When I was denied, they suggested that I invest some time in taking their "online courses" about options trading, which Ive already done. It also stated that if I made any mistakes on my application that I should make the changes and return it asap, but if the application was correct I need to wait 90 days before applying again. Should I change my investment knowledge to intermediate and return it? I have already taken the steps they suggest to take before re-applying.
When I learned i was denied i was trying to buy some Ford calls. They went up 165% the next day!

[proactiv]

Hello. New to this forum; just signed up. I'm learning about options now as well, and I am spending time at cboe.com. Some good tutorials there.. I also set up a "play" options trading account to practice, and that's where I'm really learning!

[bassmaster]

dr dave. this is a screen shot of SIRI options chain for jan 2010. if i think the price will be over a dollar, how do i go about a buy. buy to close buy to open? how many contracts can i buy?

Picture 5.jpg

[bassmaster]

sorry about the pic, i need to figure out how to make it bigger. i will repost

[bassmaster]

test------------
Picture 5.jpg