Anatomy of an option trade

Let us learn in this post about different outcomes of (anatomy of) an option trade. For example, let us see what would happen to a trade opened on IBM stocks option. IBM stock trades on New York Stock Exchange (NYSE) with a closing price of $129.61 as of 9/13/10. IBM has options listed with $5 incremental strike prices. This can be better understood with picture below. This is a call options table for IBM stock which expires on 15th of October 2010. I have purposely included October expiration table instead of September’s sice they expire in a couple days and it will be easy to follow the details of the post as the stock price moves over the next month and understand the different outcomes explained for Oct. expiration.

Numbers in the extreme left column are called strike prices. Next column represents a unique identifier of different options of IBM. Please refer to the earlier post where, I have explained the symbology of options. Last is the price at which the option traded last. Chg Is the change of options price from close of previous day. Note that all the changes are green and up since price of IBM went up and we know that call options gain when a stock price goes up. Bid and ask are the prices what buyer is ready to pay and a seller is ready sell a particular option for. Vol. is the number of options traded for that day. And last column is what is called as open interest which means the trades that are opened and waiting to be closed.

Note that there are call options above the stock price in the picture. They are called in-the-money options and the options $130 strike and above are called out-of-the-money options. Now, imagine if the stock priced closed at any of the strike prices for example at $125 or $130, then that option will be called as at-the-money option.

Don’t worry about any of the parameters that you did not understand as we will revisit them very often.

Initiating a trade:

IBM stock price closed at 129.61 by the close of September 13th, and the premium (cost) is $2.64 for an October 130 Call, which indicates that the expiration is the third Friday of October and the strike price is $130. The total price of the contract is $2.64 x 100 = $264. I did not include the commissions incurred just to make it simple (you'd also have to take commissions into account in real time).

You may recall that a call option contract is the option to buy 100 shares; that's why we multiply the contract by 100 to get the total price. The stock price must rise above $130 before the call option is worth anything since we are buying $130 strike price; furthermore, because the contract is $2.64 per share, your break-even price would be $132.64.

When the stock price is $129.61, it's less than the $130 strike price, so the option is worthless. But don't forget that you've paid $264 for the option, so you are currently down by this amount.

For the purpose of this example, let’s say the stock price moved down to $125 by Sept. 27th. The option contract has decreased along with the stock price and is now worth only $1.10 x 100 = $110.  Subtract what you paid for the contract, and now you have a loss of ($264 - $110) = $164. Where, as the real stock owner would be under water by [(129.61-125) x 100] = $469 on 100 shares. At this point you could decide to take the los and sell your option to close the position also known as “sell to close”. For the sake of this example, let's say we let it ride as there is more time left before the option expires. Now, by Oct. 8th if the stock price gained and moved to $135. The options contract will also increased along with the stock price and is now worth $6.25 x 100 = $625, and your profit is ($6.25 - $2.64) x 100 = $361. That was a wild swing from losing more than 50% in the first 10 days to a gain of over 130% in next ten days. You could sell your options here and take profits - unless, of course, you think the stock price will continue to rise and did not sell.

By the expiration date, the price drops to $128.50. Because this is less than our $130 strike price and there is no time left, the option contract is worthless. We are now down by our initial investment of $264. Well, that’s just a hypothetical analysis and we do not know what is going to happen to IBM stock price by Oct. 15th 2010 but we do know what will happen to our option price what ever the direction stock price moves.

To summarize, here is what happened to our option investment:

IBM Oct. 130 call	Sept. 15th	Sept. 27th	Oct. 8th	Oct. 15th Expiration
Stock price	$129.61	$125	$135	$128.50
Option Price	$2.64	$1.10	$6.25	Worthless
Option value	$264.00	$110	$625	$0
Profit / Loss	$0	-$164	$361	-$264

The price swing during the length of the option from a low to high was $625 which gives over double the initial investment. That is the power of leverage.

We have learned in great detail of life of an option contract in this example. This example only talks about buying a call option but there can be more trades initiated like for example, selling the same call would have given a profit of $264 to the seller.

Let me close here for now and will be back with more options stuff in the next post. Do leave your comments and suggestions and don’t forget to bookmark this blog for an easy return to free options education.