#reply-11112085
I'll give it a shot. First, the easy part. You asked about an INDEX option, and that's a kinda special case. So as not to go into Wonderland here, let's start with an option to buy something real, like a share of Wal-Mart stock.
WMT closed today at 45 1/2. WMT trades options. AS A GENERAL RULE, options contracts are traded in lots of 100 shares; in other words, if you buy one contract, you are actually buying the option to buy one hundred shares of WMT stock, so you got that part right, it's 100 shares. If the quote on the option was 2 dollars, then the ONE CONTRACT would cost $200.00.
Now, here is where it can get a little tricky. Sometimes, a stock will split, or do other things. And sometimes, the contracts for the options on that particular stock will divide up like the stock.
For example, let's say you own 400 shares of WMT. If Wal-Mart was trading at 50 bucks, and then it split 5 for 4 on July 1st, you would now own 500 shares of WMT and the price (at least the moment it split) would be 40 bucks. You still own the same VALUE of shares.
You understand that, I'm sure.
But it can happen that the option will also split, and the ONE options contract (say the August contract that started trading last January)
MIGHT (I said MIGHT) be now controlling a different amount of shares.
If the stock splits 2 for 1, it's not usually a problem. You used to own 4 contracts of WMT August 50 calls, and now you own 8 contracts of WMT 25 calls. In other words, you still control the same amount of shares, with twice as many contracts.
But if it's a weird split, the exchange may change the NUMBER of SHARES that a contract controls.
TLC (you ax) how pray tell did you discover this fact?
Don't ask.
Anyway, that can only happen on a STOCK option. You asked about an INDEX option, which is basically an option on a mental picture of some stock.
[cue Twilight Zone theme music]
The option is trading against a group of stocks, in this case the NASDAQ 100, but if you buy a call and exercise it, you don't get any stock. You get cash. The stock is *not* involved. The money you spend goes to the the firm that clears the options trades for the firm you have your account with, and the profits you make (if any) come from the loser on the trade you are in.
Minus commissions and time value decay AKA "slippage". [see Mortimer and Randall Duke in "Trading Places"]
Slippage is a very interesting term. I don't know who invented it but it was for sure a broker. Others have different words for this money that kinda drifts away to Other People That Are In On The Action.
You're travelling through another dimension....
Yes, it's the Twilight Zone. If you are trading an index option, you are basically trading in Wonderland. Not that there is anything wrong with that, mind you, it's just important to know. The "game" of index options was set up for the people that trade index options.
Stock is not involved in the calculation, only the PRICES of the stocks are figured in the calculation. Big players use these options to hedge their bets in the market. For example if you actually really OWNED the stock of each company in the NASDAQ 100, and you thought they would go down, you could buy a QQQ put. You spend a little money, but you limit your downside risk to a certain extent.
But the truth is that mostly it's just people that are playing the options game, they don't own stock, they don't care about that stuff. They want to buy some air for 8 bucks and sell it next month for 9 bucks. The winners take the money from the losers.
Now, the specifics on your question. I won't take the exact numbers you tossed out, because it's the CONCEPT you are missing maybe, and here is the concept:
The thing you are missing is the "time value" or "premium". It is EXTREMEMLY complicated mathematically, and there is no reason to study it unless you are a professional options trader. But the basic idea is pretty simple.
Let's go back to Wal-Mart. You think Wal-Mart will go up. That's fine if you own the stock. Easy, no problem. You buy it, it goes up, you sell it.
Not options. You have to know WHEN Wal-Mart will go up.
Here's why. If you want to by a Sept 45 call option, (WMT closed at 45 1/2 today) you will have to pay, let's say 2 bucks. The intrinsic value of that call option is fifty cents. You get that part, right? Stock at 45 1/2, a 45 call has an intrinsic value of 1/2.
Fine, you say, no problem. If the stock goes to 50, then my option goes to 6 1/2, up 4 1/2 on the stock means up 4 1/2 on the option.
Nope. That's the trick.
Right this minute, A Wal-Mart DECEMBER 45 call is, for example, 9 bucks. Same option, same strike price, (45), DIFFERENT (longer out) exercise date, and you pay more.
You buy that contract, then you pay more because WMT has 3 more months to go up. That's "time value".
Heh heh.
But wait! There's more! If you order right now...
There is also another mathematical calculation (actually several but we will call it one) that computes the "volatility value" of Wal-Mart. If Wal-Mart looks real strong next month, doesn't move at all (theoretically) but fits the "strong mathematics model" then the option values (premiums) go up!
What if WMT just stalls for 3 months at 45 1/2? Let's say WMT goes to 51, but it waits till December 10th to do it. At that point, your December 45 call, that you paid 9 bucks for, is worth about a 6 bucks (it's going to expire in a week).
You paid 9, the stock went the way you thought it would go, up 5 1/2 points, and you lose 33% on the play. You bought some air, held your breath for 3 months, and took a 33% hit EVEN THOUGH YOU WERE RIGHT AND THE STOCK WENT UP TEN PERCENT!
Welcome to the Twilight Zone.
This is why EBAY calls are way way more expensive for the same strike price than Bob's Fancy Donuts calls. Same stock price, same contract month, same strike price, different option price because the stock is so violent.
How's that?
Did I do it? |
