Understanding a Real Call Option

Now that you know how call and put options work, let’s take a look at some
real call and put options. Let’s pull up some quotes and see if we can make some
sense of what we’re looking at.
You can obtain option quotes for any optionable stock by going to www.cboe.
com. hat’s the homepage for the Chicago Board Options Exchange (CBOE),
which is one of the largest option exchanges in the world. Bear in mind that the
options market is open from 9:30am to 4:02pm ET (it is open until 4:15pm ET for
index options). If you are pulling up quotes after 4:02pm, you’re looking at closing

prices rather than live quotes. Also, options go through what is called an opening
rotation every morning. his is simply an open outcry system that establishes option
prices based on the current stock price openings. For this reason, you may not see
live option quotes until 9:35 or 9:40 even though the options market is technically
open at 9:30.
If you click on “Quotes” and then “Delayed Quotes” you will find a box where
you can type your stock ticker symbol. If you are looking for options on eBay,
for example, just type the ticker symbol “EBAY” and hit enter. At this time, the
shortest-term options on eBay were July ’05 (26 days until expiration) and the
longest term was January ’08 (943 days to expiration). he lowest strike is $22.50
and the highest is $80. So even though option contracts are standardized, there are
many to choose from. Table 1-1 shows some of the shorter-term options available
at the time of this writing:

Table 1-1: EBAY Option Quote

Before we continue, we need to introduce some more terminology that has
been deliberately withheld until now for the fact that it will be easier to understand
at this point. here are three main classifications for options. First, there are two
types of options: calls and puts. Second, all options of the same type and same
underlying represent a class of options. herefore, all eBay calls or all eBay puts
(regardless of expiration) make up a class. hird, all options of the same class, strike
price, and expiration date make up a series. For instance, all July $32.50 calls form
a series.


At the time these quotes were taken, eBay stock was trading for $37.11, which
you can see in the upper right corner of Table 1-1. he first column is labeled
“calls” and several columns to the right you will find one labeled “puts.” he first
call option on the list is 05 Jul 32.50. he “05 Jul” tells us that the contract expires
in July ‘05 and the “32.50” designates that it is a $32.50 strike price. he last
trading day for this option will be the third Friday in July ‘05. All you have to do
is look at a calendar and count the third Friday for July ‘05 and that is the last day
you can trade the option (which happens to be July 15 for this particular year).
Remember, you can buy, sell, or exercise this option on any day, but the last day to
do so is July 15. All 05 July options will expire on the same date regardless of the
strike price or whether they are calls or puts.
he “XBAGZ-E” notation is the symbol for that option. Just as every stock
has a unique trading symbol, each option carries a unique symbol. However, you
can forget about the “dash E,” as the letter E is a unique identifier for the CBOE,
which just tells us these quotes are coming from that exchange. If you wanted to
buy or sell this option online, you’d enter the symbol “XBAGZ.” Your broker,
however, may require you to follow this symbol with “.O” to show that it is an
option (for example, XBAGZ.O). Your broker will make it very clear if he has these
requirements, but the actual symbol (XBAGZ in this example) will always remain the same regardless of which brokerage firm you use.

If you are trading online, most brokerage firms allow you to click on the option you want and the symbol will load automatically. Just be aware that every option month and strike has a unique identifying code.

Incidentally, your brokerage firm may call the option symbols “OPRA” codes. The committee named for consolidating all of the option quotes and reporting them to the various services is called the Options Price Reporting Authority or “OPRA.” An OPRA code is the same thing as the option symbol. You can read more about OPRA at www.OpraData.com.

The $32.50 strike means that the owner of this "coupon" has the right, not the obligation, to buy 100 shares of eBay for $32.50 through the third Friday of Jul '05. No matter how high of a price eBay may be trading, the owner of this call option is locked into a $32.50 purchase price.

Now this seems like a pretty good deal since the stock is trading much higher at $37.11. It appears that if you got the $32.50 call, you could make an immediate profit of $37.11 - $32.50 = $4.61. In other words, it appears that if we could get our hands on this coupon, we could buy the stock for $32.50 and immediately sell it for the going price of $37.11 thus making an immediate profit of $4.61. However, you must remember that call options, unlike pizza coupons, are not free. It will cost us some money to get our hands on it.

How much will it cost to buy this coupon? We can find out by looking at the "ask" column in Table 1, which shows how much you will have to pay to buy the option. (We’ll talk more about bid and ask prices in the upcoming section.) The asking price shows a price of $4.90 to buy this call. This means the apparently free $4.61 is no longer free since you’re paying $4.90 for $4.61 worth of immediate benefit. In fact, we’ll show later in the course that you must always pay for any immediate advantage that any call or put option gives you. The main point is that you shouldn’t get any ideas about using options to collect “free money” in the market.

Why would someone pay $4.90 for $4.61 worth of immediate benefit? Because there is time remaining on the option. It is certainly possible that the option will, at some point in time, have more than $4.61 worth of benefit and traders are willing to pay for that time.

The $4.90 price is called the premium. The premium really represents the price per share. Since each contract controls 100 shares of stock, the total cost of this option will be $4.90 * 100 = $490 plus commission to buy one contract. So if you spend $490, you can control 100 shares of eBay through expiration. That’s certainly a lot less than the $3,711 it would cost to buy 100 shares of stock. If you buy two contracts, you would be controlling 200 shares, which would cost $980 etc.

One of the biggest benefits of options is that it allows users to form a partition of the stock’s price. If you purchase eBay for $32.50, you benefit from all price appreciation above $32.50. However, in exchange for that benefit, you are holding all of the downside risk; that is, all stock prices below $32.50 create losses.

However, if you buy the $32.50 call, you still participate in all stock price appreciation above $32.50 but do not participate in all of the downside risk. You have, in effect, formed a partition of the stock’s price at $32.50. Of course, for the benefit of not holding all of the downside risk you must pay for the option, which creates a new risk. That risk is that the stock price is $32.50 or below at expiration and you lose the entire $490.

By purchasing the $32.50 call, you have effectively shifted your risk from a stock price of zero to $32.50. This means it is more likely that you could lose the option premium (since it is more likely for the stock price to fall below $32.50 than it is to zero). At the same time, you know with 100% certainty that the most you can lose is $4.90, which is a claim the long stock owner cannot make.

Options allow users to take slices of the entire range of possible stock prices and participate only in those areas. No other financial asset allows you to do this and, as you’ll find out later, there are some fascinating strategies that emerge from this ability

Bid and Ask Prices

We mentioned the terms bid and ask in the last section but let’s take a brief detour here to talk more about what these numbers represent as they can be confusing to new traders.

Notice that the $32.50 call in Table 1 shows a bid price of $4.70 and an ask price of $4.90. You have to remember that the options market, just like the stock market, is a live auction. There are traders continuously placing bids to buy and offers to sell. The bid price is the highest price that someone is willing to pay at that moment. The asking price is the lowest price at which someone will sell at that moment.

If these terms are confusing, think of the terms you use when buying or selling a home. If you wish to buy a home, you submit a bid. Buyers place bids. If you are selling your home, you’d say I am “asking” such-and-such for it. Sellers create asking prices. Sometimes you will hear the word “offer” instead of “ask” but they mean the same thing.

If the bid represents the highest price that someone is willing to pay that means you can receive that price if you are selling your option. You are selling to a buyer and the trade can get executed. Notice that you cannot sell at the $4.90 asking price because that is a seller too and you cannot execute a trade by matching a seller with a seller.

Likewise, if you are buying this option, you should refer to the asking price to see how much it will cost you. Since the asking price shows the lowest price that someone will sell, we know you can buy the option for that price. In this case, you are buying from a seller and the trade can get executed. This is important to remember since the price you pay or receive depends on the bid and ask. Maybe this trade appears to be a good deal if you could sell for $4.90 but you would be disappointed if you find that you only received $4.70.

You need to be aware of which price applies to your intended action. In summary, if you are selling then you should reference the bid price. If you are buying, you should look at the asking price. This is especially critical for options traders since the volume on options is not as high as it is for the stock and, consequently, options will have larger spreads between the bid and ask.

For example, take another look at Table 1, which has been reproduced below:

Table 1 (Reproduced)

You can see in the upper right hand corner that the stock is bidding $37.10 and asking $37.11, which represents a one-cent spread between the buyers and sellers. However, the $32.50 call option is bidding $4.70 and asking $4.90, which is a 20-cent spread. The bigger that spread, the more critical it is to understand what the bid and ask mean, otherwise you could be in for an unpleasant surprise when trading.

Okay, let's try the next call on the list in Table 1, the 05 Jul 35 call. (Notice that eBay is below $50 and the strikes are in $2.50 increments, which are in agreement with what we said in a previous section). If you buy this call option, you have the right, not the obligation, to buy 100 shares of eBay for $35 per share through the third Friday in July '05. Since eBay is trading for $37.11, we know that anybody holding this option has an immediate advantage of $37.11 - $35 = $2.11 by buying this call and we now know that this advantage must be reflected in the price.

You can verify that the asking price is $2.70, which means the apparently free $2.11 benefit is not free. Again, the reason traders will pay more than the $2.11 benefit is because there is time remaining on the option and it certainly could end up with more value. If you want to buy this contract, it will cost you $2.70 * 100 shares = $270 per contract commissions. If you buy two contracts, you would control 200 shares and that would cost $540 and so on.

While we’re talking about the prices in Table 1, let’s explain what the rest of the columns mean. The LAST SALE column shows the price of the last trade of the option. Option traders rarely look at this since that price could have occurred during the last minute but it also could have been last week. We don’t know when that trade took place. We just know that was the price when it last traded. For stock traders, the last sale will generally be very close to the bid and ask of the stock because optionable stocks generally have high volume but that is not necessarily true for their options.

In Table 1, you can see that the last trade on eBay was $37.11 with the bid and ask at $37.10 to $37.11. The last sale is very close to the current bid and ask and this will usually be the case. But notice that the last trade for the $32.50 call was $4.40 with the bid and ask at $4.70 to $4.90. This shows that the last trade is somewhat stale and that’s why option traders generally do not look at the last sale numbers. If you were buying this option, the last sale would lead you to believe that it would cost $4.40 when it would really cost $4.90. If you were selling the option, the last sale may make you decide against it since it appears you would only receive $4.40 when, in actuality, you get $4.70.

The NET column shows the net change between the last trade and the last closing price just as it does for stocks. For the July $32.50 call, the last trade was $4.40 and that price was down $1.20 from its previous close, which means the option must have closed at $4.40 $1.20 = $5.60. If this option closed at $5.60 and the next trade was at $4.40 then that represents a $1.20 drop in price, which is what the NET column shows.

Again, the reason for the apparent big drop in price is because there was a big time delay between the last sale and the previous closing price. Remember, stocks have a lot of volume and they trade right up until the market close. That may not always be true for an option. This option’s closing $5.60 closing price may have occurred several days ago.

The VOL column shows us the volume, which is simply the number of contracts traded that day. For the stock market, volume refers to the number of shares traded; for the options market, it refers to the number of contracts but the idea is the same.

The OPEN INT column shows how many contracts are currently in existence, which is called the “open interest.”

Whenever you buy or sell a contract, you must specify whether you are entering or exiting the contract. If you are entering into the contract (or increasing the size of an existing position) then you are “opening” the contract. However, if you are exiting the contract (or decreasing the size of an existing position) then you are “closing” the contract.

Most brokerage firms require that you specify whether you are opening or closing the position. For instance, if you wish to buy 10 Microsoft July $30 calls you would enter the order as “buy to open” 10 Microsoft July $30 calls. You would not say “buy” 10 Microsoft July $30 calls. The reason is that the word “buy” alone doesn’t tell the broker if you are buying the calls to own them (opening transaction) or if you are buying the calls to close a short position (closing transaction). Using the words “to open” or “to close” clarifies your intentions.

Some of the newer firms do not require the use of the words “opening” or “closing.” Instead, they account for it based on the existing positions in your account. For instance, if you have no Microsoft July $30 calls then the above order is recognized to be an opening transaction. On the other hand, if you were short 10 Microsoft July $30 calls then the order is recognized to be a closing transaction.

Every time the buyer and seller are entering an “opening” order it adds to the open interest. For instance, if you are buying 10 contracts to open and the seller is selling 10 contracts to open then open interest is increased by 10.

If the buyer and seller were, instead, both entering “closing” transactions then open interest would decrease by 10 contracts. Finally, if one is entering an “opening” transaction while the other is entering a “closing” transaction then that order has no effect on the open interest.

Open interest provides a measure of how many contracts are currently in existence and therefore provides a measure of liquidity. That’s what the open interest column shows.

Understanding a Real Put Option

Now that we’ve looked at a couple of call options, let’s take a look at some real put options. Once again, Table 1 has been reproduced below. Take a look at the 05 Jul 32.50 in the right column (red box). What does this put option represent?

Table 1: (Reproduced)

If you buy this put, you have the right to sell 100 shares of eBay for $32.50 per share through the third Friday of July ’05. For that right, you would have to pay 0.20 * 100 = $20 plus commissions.

No matter how low of a price eBay may be trading, you are guaranteed to get $32.50 if you exercise this put option to sell your shares. Remember though, you do not need to own the shares of stock to buy a put. By purchasing this put, you have the right to sell shares for $32.50 and somebody else will be very willing to buy this from you if eBay falls below $32.50. If you think the price of eBay will fall, you can buy the put and then sell it to someone else thus capturing a profit without ever having the shares in your account.

Notice that with this option, there is no immediate benefit in owning the $32.50 put. If you owned shares of eBay and wanted to sell, you’d just sell the shares in the open market for $37.11. Once again, the reason there is any value to this $32.50 put at all is because there is time remaining and it may end up with a lot more value if eBay’s price falls. Traders are willing to pay for that time.

Let’s try another one on the list, the 05 July $37.50 put. If you buy this put, you have the right to sell 100 shares of eBay for $37.50 per share through the third Friday of July ’05. Now this put does appear to have an immediate value since we could sell the stock for a higher price than it is currently trading. It appears that if we buy this put, we could buy the shares for $37.11 and immediately use the put option and collect $37.50 for an immediate guaranteed profit of 39 cents.

As with our call option examples, any immediate benefit must be paid for and we can verify that by observing the $1.40 asking price. In other words, you’re paying $1.40 for that 39-cent immediate benefit. The market is willing to pay more than the immediate benefit since there is time remaining on the option. You cannot use options, whether calls or puts, to collect “free money.”

Key Concepts
1) he price of an option is called the premium.
2) he “ask” price tells us how much we have to pay for an option. he “bid” price 
tells us how much we can sell it for. 
3) To find the total price for one option contract, multiply the bid or ask 
by 100.
4) he last day to trade an option is the third Friday of the expiration month.