Author Topic: Basic Options Questions  (Read 10738 times)

racemize

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Basic Options Questions
« on: March 15, 2013, 07:27:45 AM »
I thought it wouldn't be a terrible idea to have a thread to ask more basic, general questions.  I'll start:

What's the typical terms for the following price points? (I've put my own terms in parenthesis--I presume the bottom two are wrong):

1) options will expire valueless at current prices (out of the money)
2) options will expire with value at current prices (in the money)
3) options will expire with a value greater than your strike + premium (break even point?)
4) options will expire with a value greater than if you had put the equivalent amount of money in the underlying (switch over point?)



compoundinglife

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Re: Basic Options Questions
« Reply #1 on: March 15, 2013, 07:50:42 AM »
I thought it wouldn't be a terrible idea to have a thread to ask more basic, general questions.  I'll start:

What's the typical terms for the following price points? (I've put my own terms in parenthesis--I presume the bottom two are wrong):

1) options will expire valueless at current prices (out of the money)
2) options will expire with value at current prices (in the money)
3) options will expire with a value greater than your strike + premium (break even point?)
4) options will expire with a value greater than if you had put the equivalent amount of money in the underlying (switch over point?)

Not sure if there is a term for #4. But 1,2,3 sound right. 3 is sometimes referred to simply as "breakeven" and there is also "at the money" when the stock is trading at the strike.

There is also "intrinsic value" which is the value of the option if it were to expire today. For example the 2015 $10 BAC Leap has an intrinsic value of approx $2.53 at the moment. The remainder of the value ( 3.60 - 2.53 ) is time value, premium or "extrinsic value".

racemize

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Re: Basic Options Questions
« Reply #2 on: March 15, 2013, 07:56:30 AM »
yeah, #4 is my main question, the other ones are a bit more straight forward.  Thanks for the response!

constructive

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Re: Basic Options Questions
« Reply #3 on: March 15, 2013, 12:40:05 PM »
I'd call #3 breakeven (vs cash) and #4 breakeven vs common

Sunrider

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Re: Basic Options Questions
« Reply #4 on: March 16, 2013, 10:39:29 AM »
Hello - not entirely sure they all have points (or at least it doesn't trigger memories of my finance classes coming back)!

1. Out of the money, OTM, below strike price
2. In the money, ITM
3. Breakeven (should be strike + premium you paid though)
4. Not sure I follow. In pretty much any likely case I can think of, the option premium will be much smaller than the strike price (ignore a, say, apple call with strike 25) and so 'the amount of money invested' in the option will be fairly small, or alternatively, the equivalent amount of stock bought will be small (i.e. < 1.0 common exposure can be purchased in common stock for the premium typically paid for the option). So the profit you will make as soon as the option is sufficiently above the breakeven point will in all likelihood always be greater than the profit you would make from investing the same amount in common after the aforementioned point. Generally this point will depend on how expensive the option was - you'll gain more on the option than the equivalent common if the stock rises sufficiently to compensate for the volatility priced into the option contract.  If it doesn't then you  do better with the common.


Speaks to the leverage inherent in the product. So I don't think I've come across a specific name for this. Of course you could end up buying a very very expensive option and so you may end up doing better with the common where the price just about exceeds your break-even.

Stock at 5. Option at 5.5 strike at 0.5. Ignoring multipliers:
(a) Buy option at 0.5
(b) Buy 0.5 worth of common (so 0.5/5 = 0.1 shares)

Scenario - stock at 5.51 at expiration - payoffs
(a) 0.01 - a loss of 0.49c
(b) 0.1x0.51 = 5.1c

Scenario - stock at 6.01 at expiration
(a) 6.01-5.5-0.5 = 0.01
(b) 0.1 x (6.01-5) = 0.11

Scenario - stock at 7 at expiration
(a) 7-5.5-0.5 = 2
(b) 0.1 x (7 - 5) = 0.2


You can see this as a form of volatility trading - if you think the option contract is priced at a volatility level higher than what you think will be realised, sell the option (and ideally perpetually hedge-out the delta all the way to expiration). If the option seems to not price in the volatility you expect, then buy it (again, if you're able to hedge-out the delta then you can make an arbitrage type profit).


I thought it wouldn't be a terrible idea to have a thread to ask more basic, general questions.  I'll start:

What's the typical terms for the following price points? (I've put my own terms in parenthesis--I presume the bottom two are wrong):

1) options will expire valueless at current prices (out of the money)
2) options will expire with value at current prices (in the money)
3) options will expire with a value greater than your strike + premium (break even point?)
4) options will expire with a value greater than if you had put the equivalent amount of money in the underlying (switch over point?)

racemize

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Re: Basic Options Questions
« Reply #5 on: March 16, 2013, 11:38:34 AM »
I didn't quite follow everything you said, but I think we are referring to the same thing.

This point I am referring to is the same as the final point in Eric's cost of leverage calculation. For example, using the a warrants, the break even is ~19, but it isn't until ~25 that you do better with putting the money in warrants as opposed to common.

Sunrider

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Re: Basic Options Questions
« Reply #6 on: March 16, 2013, 02:59:32 PM »
I didn't quite follow everything you said, but I think we are referring to the same thing.

This point I am referring to is the same as the final point in Eric's cost of leverage calculation. For example, using the a warrants, the break even is ~19, but it isn't until ~25 that you do better with putting the money in warrants as opposed to common.

As per the other thread - I think Eric's calculation only makes sense given the scenario you pick to do the calculation actually comes about. Failing that, you just don't know. (Or if you assume you roll to warrant expiration, given the assumed price path and prices at the times of roll.)

So yes, you can calculate such a point, but only for a chosen outcome, not across the range of all scenarios that may materialise (because it would differ for each of them, so you'd then have to take some sort of average, which doesn't really help you, I think).

Good night.

C.


racemize

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Re: Basic Options Questions
« Reply #7 on: March 16, 2013, 10:59:06 PM »
Sorry, I needed to be more clear--the number is the same, but what I'm talking about is different. 

More specifically, I'm talking about the break even point where the gains from warrants at expiry and the gains of common are the same, so this is a factual number that is independent of any path to get there.  Here's the calculation, at current prices:

current stock price:
$12.57
$5.69

The break even point vs common that I'm talking about happens to be at $24.30, ignoring dividends.  So, to prove the point:

At $24.30, the common has gained 93%
At the same price, the warrant is worth 24.30-13.30 (assuming no adjustments)=11.00, which is a gain of 93% from 5.69

Thus, you should only buy the warrants versus the common if you think the price will be greater than that break over point.  Same thing with the options.  For the 2015 LEAPS, that happens to be 14.90, ignoring dividends.




Sunrider

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Re: Basic Options Questions
« Reply #8 on: March 17, 2013, 08:53:30 AM »
I see what you're getting at. Still don't know if that's got a name though. :)


Sorry, I needed to be more clear--the number is the same, but what I'm talking about is different. 

More specifically, I'm talking about the break even point where the gains from warrants at expiry and the gains of common are the same, so this is a factual number that is independent of any path to get there.  Here's the calculation, at current prices:

current stock price:
$12.57
$5.69

The break even point vs common that I'm talking about happens to be at $24.30, ignoring dividends.  So, to prove the point:

At $24.30, the common has gained 93%
At the same price, the warrant is worth 24.30-13.30 (assuming no adjustments)=11.00, which is a gain of 93% from 5.69

Thus, you should only buy the warrants versus the common if you think the price will be greater than that break over point.  Same thing with the options.  For the 2015 LEAPS, that happens to be 14.90, ignoring dividends.

scorpioncapital

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Re: Basic Options Questions
« Reply #9 on: March 20, 2013, 07:05:51 AM »
Is there a way to price future option prices?

Example.

Stock is at 25.
Option strike is 30 put expires in 7 months.
Premium is 50 cents.

Now in month #2, stock goes to $29 or $30.
Expiration is now 5 months away.

Is there a way to predict the premium price of the option at this point? Is it reasonable to assume double, or could it be triple or quadruple.