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Stock Options Defined |
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Stock Options Defined |
Here is our explanation of options, with definitions and comments. You might want to print this for future reference and get more free information at web site www.splitmaster.com.Call Option--An option is a contract that allows the purchase of stock at a certain price for a certain period of time. It usually is for 100 shares, altho there are times when it is for less---so be very careful and check if you see two different symbols for the same strike price (see Strike Price). There are also options in real estate, where you are allowed a certain period of time to buy property at an established price. You pay a price for that right to buy the stock. Example: IBM closed at 115.37. You can buy an option giving you the right to buy IBM at 110 until Feb. 18 and the price is 6 1/8 bid, 6 3/8 ask. That means that if you are buying you would pay 6 3/8 and if selling, you would receive 6 1/8. There is the chance that you could do better but the bid is the highest that someone is willing to buy at, and the ask is the lowest someone is willing to sell at. Sometimes it goes in between. You can either buy or sell the option and you are not required to buy the shares, or exercise the option, as it is called. You can, but you don't need to. You can buy or sell the option anytime up to closing on the last day of your time period. If you have an option in a stock that splits and you own the option after the stock split occurs, you will have the added number of options, based on the split ratio. Example: If the stock splits 2-1 and you had originally bought 1 option, you would have 2 options when the stock splits. The strike or exercise price would be 1/2 of what it originally was. If the strike price was 100, it will now be 50. See the definitions of strike price, exercise price, etc. below. The first 3 letters of the option symbol represent the stock involved. If it is a NY Exchange stock, the first 3 letters will be the same as the NY stock symbol. Expiration Date--- This is the date on which your right to buy or sell the option expires. It is always the 3rd Friday of the month. There are expiration dates for each month. Some future months are shown, but usually the options exchange waits until one month expires before showing the 2nd month from there. Example--If we are in February you can see options on Feb. and March, but not April. As soon as the Feb. option expires, you will see March and April, and so on. You have to be careful about that 3rd Friday. Some months are shorter or longer, depending on the date of the first Friday. The longest month occurs when the 1st of the month is on Sat. and the shortest month occurs when the 1st of the month is on Friday. The option symbol showing the month of the expiration is the 4th letter of the option symbol. All options have the same letter for the month of expiration. A is January, B is Feb., C is March, etc. Strike Price or Exercise Price--- This is the price that you are allowed to buy the stock at. The options are usually in $5 increments. In IBM, for example, you can get them at 110, 115, 120, etc. At low prices, they shift down to 2 1/2 point increments. When a stock splits, the prices are adjusted to the ratio of the split, and sometimes there are odd exercise prices. Example--A stock splits 3-1 and the old option exercise price was 100. The new option will be 33.33 and then adjusted to nearest 1/8 or 33 3/8. Currently check GDW, which did split 3-1. The 5th letter of the option symbol denotes the price at which the stock can be bought, the exercise price. Again, using GDW as an example, the symbol for the March 25 option is GDWCE, and the E means the exercise price of 25. The full symbol--GDW signifies the stock, C signifies the month of expiration (March) and E signifies the price you can buy the stock at (25). Break Even--This is the price that the stock needs to reach for you to be sure to break even. Example: If you buy the IBM Feb. 110 option and pay 6 3/8 for the option, you need to add the strike price (110) and the option cost (6 3/8). That would be 116 3/8. Since the price of the stock is 115 3/8, you need to see the stock go up 1 to break even. So--add strike price and option cost to get Break Even. True Value or Intrinsic Value---This is what the option is truly worth. To get this you take the difference between the current stock price and the option strike price. Example: IBM is currently 115 3/8. You are looking at the Strike price of 110 (any month). The true value of the option is 5 3/8. Premium---This is where we differ with common definitions. The Exchange says that the premium is the price you pay for the option. We break the option down to True Value and Premium that is out-of- the money. We say the amount of the option cost that is above true value is premium--it has no value. In our IBM example, the Feb. 110 sells at 6 1/8, with the stock at 115 3/8. The true value is 5 3/8 and the premium is 3/4--the difference between true value and the option price. The option is 3/4 out-of-the- money, or needs to go up 3/4 to break even. Note--we are using an option selling price of the bid side so it is 6 1/8, not 6 3/8--we would pay 6 3/8 (ask) to buy, and we can sell at 6 1/8 (bid). Remember, we refer to Premium as the part of the option that has no current value. It is out-of-the-money. Deduct true value from option cost and you have premium, as we refer to it. Our IBM example is very low, for 2 reasons. One is that there is only one week left currently (2-11) before the option expires. The 2nd reason is that IBM doesn't have as much volatility as internet stocks, for instance, so its premium is lower. Those internet stocks can easily have 20 points premium in them when there is a month to go to expiration. It hurts to buy them like that but they often make money as shown in our split data. Options to Open---This is the term that the brokerage house needs when placing an order. It means simply that if this is your first position in the option, you are opening a position, so you would say--I want to buy "X number" of IBM Feb. 110 calls (symbol) to open. Options to Close--When you sell the option you say, I want to sell "X number" of IBM Feb. 110 calls (symbol) to close. That will close out your position. The broker needs to know that because it is possible to sell and option to open a position---usually in covered call writing. But that is another story and I don't want to confuse you with it There are also a number of other option possibilities, but they are technical. For use with our split system, these above definitions are what you would be using to transact trades. Memorize the definitions to get a full understanding and refer to the CBOE site for examples. For instance, memorize the definition of True Value as--The difference between the current stock price and the option strike price (the strike price of the option you are interested in). If the current stock price is lower than the strike price, there is no True Value. Example IBM Feb. 120 option. The current price of the stock is 115 3/8--you have the right to buy at 120. There is no true worth or value in the option. It is all premium (out-of-the-money). Many people buy these hoping to hit a home run, as the option is cheaper than one that has true value. Below I will show the policy that I use for buying options in stocks that are splitting. This is my own personal choice and in no way is it a suggestion to you. You make the final decision. My option goal is to buy whichever option has the first strike price below the current price of the stock. For instance, if the stock is 64, we would be looking at the strike price of 60. Then, we want an expiration that is the first option expiration date beyond our listed Sell Date. For example, if your sell date is Jan. 27, we would be buying the Feb. option, as that means the Feb. option expires Feb. 18---all options expire on the 3rd Friday of each month. Putting all that together, we would be looking at the Feb. 60 options for the example. There are a couple of times this would be different. If the stock is 61, the next lowest option strike price would be 60. Usually the option price has too much premium at 60, so I look to the 55--and even sometimes the 50--if there isn't too much difference in price. As you approach option expiration date the option loses much or most of its premium and gets down to true value. Many times the bid price of the option will be below the current price, which means that if you sell the option you will get less than true value. When that happens email me and I will tell you what I do to counteract that. It makes me very angry that the market maker of the option takes such an unfair advantage of the seller at these times--besides the spread difference he makes in the bid/ask prices. For one option it might not make enough difference to take other steps, because of added commissions involved. If you pay $20-25 minimum commission for options (1 option) that might be the case. If you have more than 1 option, it might be worthwhile to take other steps-- Now some of you may have heard part of this before, but we like to explain it for our newcomers. We suggest that even if you are just following our picks, try to papertrade the options, if you have an interest in options. The subscribers should be checking www.cboe.com to write down the option that would be of interest to them--pick the strike price, the month, and the current option price--and also list the current stock price at the time you do that. The current stock price shows on the CBOE page, too. You know when we are showing the buy, at the open, so you should check the option page at that time, preferably. Non-subscribers can do the same thing on stocks they are interested in, or stocks that have announced a split. Finally, please remember that we do not give stock advice. We publish computer research and we invest for ourselves. Our figures are based on getting some of every stock published--(or options). The Big Dipper System requires far less capital to buy some of each published stock. You determine your own amount to invest and you decide which stocks to purchase in your own individual accounts. If dealing in options, please make sure you become knowledgeable. Knowledge is key. We try to furnish this research information to serious investors and hope they may benefit from our computer studies. Good Hunting--
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