Options 101: Example Trade
International Business Machines (Ticker: IBM)
March 15, 2004  $91.79  -$1.51
| Symbol |
Last |
Time |
Net |
Bid |
Ask |
Open |
High |
Low |
Close |
Vol |
| IBM |
91.79 |
11:14 a.m. EST |
-1.51 |
0.00 |
0.00 |
92.60 |
92.69 |
91.60 |
93.30 |
1565000 |
| Mar 2004 |
| Calls |
Last |
Net |
Bid |
Ask |
Vol |
Open
Int |
Strike |
Puts |
Last |
Net |
Bid |
Ask |
Vol |
Open
Int |
| IBMCQ |
6.70 |
-0.80 |
6.80 |
6.90 |
43 |
356 |
85 |
IBMOQ |
0.05 |
0.00 |
0.00 |
0.05 |
0 |
1695 |
| IBMCR |
2.30 |
-1.20 |
2.20 |
2.25 |
338 |
2941 |
90 |
IBMOR |
0.40 |
+0.15 |
0.40 |
0.45 |
1073 |
8940 |
| IBMCS |
0.15 |
-0.30 |
0.10 |
0.15 |
758 |
12534 |
95 |
IBMOS |
3.30 |
+1.15 |
3.20 |
3.40 |
4201 |
17802 |
| IBMCT |
0.05 |
0.00 |
0.00 |
0.05 |
91 |
25120 |
100 |
IBMOT |
8.10 |
+1.30 |
8.10 |
8.30 |
167 |
8526 |
|
| Apr 2004 |
| Calls |
Last |
Net |
Bid |
Ask |
Vol |
Open
Int |
Strike |
Puts |
Last |
Net |
Bid |
Ask |
Vol |
Open
Int |
| IBMDQ |
8.90 |
0.00 |
7.40 |
7.60 |
0 |
2625 |
85 |
IBMPQ |
0.70 |
+0.20 |
0.65 |
0.70 |
98 |
14428 |
| IBMDR |
3.80 |
-0.90 |
3.60 |
3.80 |
113 |
11795 |
90 |
IBMPR |
1.85 |
+0.40 |
1.85 |
1.90 |
674 |
25820 |
| IBMDS |
1.30 |
-0.55 |
1.30 |
1.35 |
548 |
25008 |
95 |
IBMPS |
4.40 |
+0.80 |
4.40 |
4.50 |
1.49 |
15536 |
| IBMDT |
0.30 |
-0.25 |
0.30 |
0.40 |
426 |
27845 |
100 |
IBMPT |
8.50 |
+1.20 |
8.40 |
8.60 |
467 |
5106 |
|
Sample Trade
Using the IBM option table above, start with the premise that an investor believes that IBM is going to reach $100.00 per share by the end of April. It would appear that the April $90.00 strike appears reasonable at $3.80 per call contract. The investor purchases 1 contract, which cost $380.00, plus commission (remember that virtually all equity option contracts represent 100 shares of the underlying stock, therefore always multiply the price by 100).
The IBMDR options expire on Friday April 16th. (Equity options expire on the third Friday of the stated month). From the example date of March 15, 2004 until the expiration there are 22 trading days. This leaves a fair amount of time for the stock to make a meaningful move, both upward and downward. This potential to move in the time given is priced into the option. In these 22 days it's entirely conceivable for IBM to move up 5% from the $91.79 to $96.38. In this case the option contract would have to worth at least $4.59 ($91.79 - $96.38 = $4.59), representing a 21% gain in the option price. In all likelihood it would be worth more if there were still many days left because of the time premium. If stock is volatile then the odds of moving 10%-20% in 4 weeks is not inconceivable.
If the stock does indeed move to $100.00 per share, at a minimum the option will be worth $10.00. This is because the holder of the option has a right to buy 100 shares of IBM for $90.00 and since it's trading for $100.00 the fair value of the option will be $10.00. The gain on this option would be $620.00 ($10.00 - $380.00) or 164%.
In the above example the price of IBM is trading at $91.79 yet the option price is $3.80 on the ask side. A reasonable question would be why is the option not priced at $1.79, after all I have the right to buy 100 shares for $90.00 and then turn around and sell them for $91.79, profiting a quick $1.79 per share or $179.00. The reason for the higher price is the premium.
Risk
Options carry an extremely high degree of risk and are considered a zero sum game. In the example above the $380.00 investment can become worthless if the IBM shares drop by 10% and do not recover by the April expiration date. The option will expire worthless. Keeping this in mind, traders that are new to options should paper trade them before actually investing to learn and understand their characteristics.
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