Option Trading 201: The Mechanics Behind a Call and Put Option Contract
- Hello and welcome to the rookie's course on option trading. My name is Brian Overby, I am the Senior Options Analyst at Ally Invest and author of "The Options Playbook." All right, so the basics, Options 101 is in the books.
It is on demand inside the Ally YouTube channel. We talked about the vernacular of the marketplace. A lot of times it's tough to make that exciting, but it's a must do if you wanna learn how to trade options.
Today, we're gonna get into Options 201, The Mechanics. We're gonna talk about the guts of the marketplace. We're gonna define what an option contract really is and get into the pricing of the option contract and talk about important terms like open interest in volume, and really explain how much different trading options is versus trading stocks outright. Then we're gonna come back tomorrow, same time, 2:30 pm Eastern Time and we're gonna finally get into the strategies.
Now today's session, I think is the most important session. A lot of times, when you see a lot of rookie's option courses, they ignore the fundamentals and they get into the strategies way too quickly. So when we come back tomorrow, we'll have the foundation late and we'll start talking about option trading strategies. Now, I wanna emphasize that everyone is welcomed. If you go to ally.com/optionsforrookies, you can actually register for the next event that's going to be tomorrow.
And you can also share that with your friends on social media, let them know about it, this is free for all. We want to teach everybody the fundamentals of option trading that would like to learn. We wanna make sure that you have that solid foundation because option trading is 100% different than trading stocks and you do need to do your homework before you dip your toe in the water. So with that said, let's do a little bit of review. As far as options are concerned, we're showing on the screen here, that options are contracts.
And we started with that yesterday in 101, but it's really important today because we foreshadowed a little bit at the end of the event that we're gonna talk about things like open interest and how that is affected by the fact that an option is an actual contract. We mentioned at the end of the show that, well, if nobody trades the contract, well, then does the option really exist? And if you think about it, an option does not exist until somebody buys it or somebody sells it. And this is the example that we used yesterday. We have two different, the two different flavors of options. We have calls and we have puts. And we talked about the fact that a quote is really just an advertisement for an option contract.
You can quote it all day long, the exchanges will open up these contracts and quote them on their option chains, which we highlighted an option chain yesterday, and we'll look at more option chains today overall, but when we did that, when we went through and we looked at that contract, it was very clear that unless somebody writes the contract and somebody buys that contract, that the option really doesn't exist. And that's gonna be where we're gonna start today. So what are options? Let's just review really quickly.
It's a contract that gives the owner the right to buy or sell an asset at a fixed price for a specific period of time and obligates the seller to take the opposite side when the right embedded in the contract is exercised. Now that's in the body of the contract, we don't say that anymore because everybody, basically the trades options understands that. And the quote really lays out all the important points of this option contract overall. All right, so we need to talk a little bit about strategies, strategies is the session tomorrow, but we're gonna talk about the four basic things that you can do with an option contract. If you buy a call, you're going to have the right to buy the underlying stock.
You would be considered a long that position in your account after you bought that call option. Now on the put side, if you buy a put, you're gonna have any right to sell the underlying stock, everything else applies at that strike price and once you buy it or once you bought that option contract, you would be considered long that put in your account. Now, if I buy a call, I have a right to buy the underlying stock.
That means I do want the underlying stock to go up, that would be my goal if I'm buying that call option outright. If I buy the put, I've the right to sell the underlying stock, if I'm looking to sell, I'm buying with the intention to sell, that's where puts kind of gets a little bit more confusing than calls, but that means that I want the underlying stock to go down so then I can sell it at a higher price via the strike price. Now on the opposite side of the coin, when you sell options, in the options marketplace, it's very easy to sell an option contract without owning it. It's much different than the stock marketplace, the stocks market place overall.
But when I sell a call, I'm gonna take on an obligation. I'm gonna get paid for taking on this obligation and then I would be considered short that contract and also be considered the writer of the option contract, which is very important because we talked once again about insurance, and we're gonna bring that up again how the options marketplace is very similar to the insurance marketplace. And then if I sell a put, I'm gonna to take on that obligation to buy, after I sell it, I would be considered short and I'd also be considered the writer of the put option contract. All right, so let's say we did one of those things. Let's say we bought a call or bought a put, or sold a call or sold a put. Once we do this, what happens? What are our options after we have gotten into an option position, inside our account? Now this section right here is probably where I get the most questions in options.
And I'm gonna highlight inside "The Options Playbook" website, the fact that we've actually put this in the rookie's corner. So I'm gonna show you that here in just a little bit, but with that said, so you bought an option or you sold an option, you are considered long or short that position. What are the three things that we can do? Well, first of all, you can buy or sell to close the position prior to the expiration date, you can, if the options expire worthless, that means that they were out-of-the-money. You rode the option contract all the way to the expiration date, there's no value because they're not in-the-money and so then the option expires worthless. Now that's bad if you bought the option contract, but that's good if you sold the option contract to initiate that position.
And then last thing is the option contract expires in-the-money, usually resulting in a trade of stock. If you rode it all the way to the end and you're in-the-money, it usually behooves you to actually exercise your option contract and buy the underlying stock if it's a call or sell the underlying stock, if it's a put. So the chat box is opened up over here on the right hand side of your screen, I'm gonna leave that open for questions.
And in particular, I'm gonna address any questions that you may have on this topic when we're through with this one slide overall 'cause I do anticipate quite a few questions. And I'm gonna start by giving you a quiz, a little bit of a quiz. Out of these three choices, option one, option two, option three, which one do you think happens the most? That people close the position, that they expire out-of-the-money and worthless, or that they actually get exercised and result in a trade of the underlying stock. So you have one, two or three. You can write it in the chat box real quick, like I'll take a peek at it and see where we're at and just type one, two or three, you don't have to write it all out.
And I'm just curious to see what you think happens the most often out of these three choices overall. All right, so I'm gonna just jump right on, but since I can't see everybody's face and see exactly where they're at, I do want you to answer, I do you wanna see them inside the chat box. So you can see all the different answers that are coming in right now on the Ally YouTube Channel chat box and I'm gonna go to the next page and here are the outcomes.
So basically I'm showing a little pie and this is from the Options Clearing Corporation. They've been keeping track of these numbers since 1973, since the Chicago Board Options Exchange opened up their doors and first started trading options. This is the company that clears all the option contracts that's behind the scenes. And they've realized that about 70% of the time, most people just close out their positions.
And a lot of people will say that most of the time they expire worthless, which is just not the case, about 20% of the time they expire worthless and only about 11% of the time do they actually get exercised. So let's talk a little bit about this. A lot of people that just focus on call options just for a second. If I buy a call option, I am buying the right to buy the stock.
A lot of people will use the phrase that you are renting the stock. Now, why am I buying that call option? Well, could be the fact that I don't want all the risk of just owning the stock outright, if I was thinking about buying 100 shares of stock on an expensive underlying, that's a lot of risk, as opposed to just buying an option contract, I'll have limited time for it, but I'll also have limited risk to the premium that I paid for the option contract. So I bought it, the position is going right, I see that option go up in value as it becomes in-the-money which we talked about in the 101 show and I could exercise, but why? I can just go out and close my position, take my gain and move on.
And guess what, most people do that. Or the opposite happens, the market is going down, I bought this option contract I paid real money for it and it's going down in price, I might sell and get out and cut my losses. The listed options marketplace makes this feasible to be able to buy and sell option contracts at a decent, you might not always think that it's decent, but at least at an okay bid and ask price, which we're gonna be highlighting here just shortly. Lastly, exercised, 10% of option contracts do get exercised and they could be exercised. I'm gonna talk about a strategy tomorrow called a covered call, meaning that I'm trying to sell my stock at a higher price.
Sometimes you want it to be exercised and you want them to take that stock away 'cause you're selling the stock higher. Or maybe I just want the stock. Maybe I bought that option contract, I limited my risk and I just want that stock.
Or maybe I bought a put option, I own the stock. The stock was going down in price and I'm like, oh my gosh, I am losing on my sock. Oh, wait a minute, I have a put that says I can sell this stock at the strike price.
Why don't I exercise and do that and sell my stock at a higher price via the put? So most of the time that people are trading option contracts, they're going to be closing out that position and that creates a vernacular in the marketplace that's a little different than stocks. Since it's so simple to actually sell an option contract without owning it, basically, if I'm gonna sell, I want to be able to tell the broker and the exchange that I'm opening the position. So you will see when you go to the Ally Invest Option Trading screen, a dropdown.
And in there you will see, buy to open, sell to open, buy to close, sell to close. And you will have to mark that ticket accordingly, if you are long the option contract, you would be selling to close. If you are not long the option contract, and you're looking to just sell to get into that position, you would be selling to open on that trade overall.
And once we do this, the Options Clearing Corporation uses those tickets to try to calculate the number of actual contracts that are available or that are out there in the marketplace. As we said before we began, if nobody trades the option, even though it's being quoted, that option contract really doesn't exist in the marketplace overall. So how do we keep track of how that marketplace exists? We do that by a term called open interest.
All right, so I'm going to go right now, I'm gonna exit this little thing and I'm gonna take a peak at closing out these positions. So here's "The Options Playbook," and I'm highlighting it right now. And in the options basics session, we talk about cashing out your option and we go into a lot of detail on that because I get so many questions.
As a matter of fact, a lot of the emails that I'll receive asking me questions, a lot of times I just have to send this one page and it explains a lot of them. Then on the very next page, we actually have Keeping Tabs on Open Interest. So if you would like to follow up this video by reading these two little pages inside "The Options Playbook," it's very feasible to go and do that overall.
All right, so if you have any questions about open interest right now, I would be happy or I should say about closing out your options, I would be happy to address them. I will take a peek at it inside the chat box and look for any questions that we may have. And first of all, we do have a question from Clinton, questions about IV.
On a stock, IV is presented as a numeral, is that dollar amount one, minus the standard deviation. All right, now that Clinton, we're gonna address in about three more slides. So right now I just wanna keep it focused on closing out positions. All right, so let me go back to the presentation and let's talk a little bit about the open interest then. So what is open interest? We don't have open interest in the stock world, that terminology or that phrasing does not fit stocks.
The closest thing I guess, would be number of outstanding shares that are available to trade. In the options world, open interest literally means people that are interested in that option contract. So let's define it. Open interest is the number of option contracts that exist for a particular stock. Now open interest can be tallied as large of a scale as all the contracts on a stock, this stock has a large open interest on put options and call options, but more specifically, you usually see it as on a quoted line on the actual strike price, which I'm gonna highlight in this figure here on our right.
And it will apply to that option strike price. So for example, here's a fictitious example of an option chain that you might see on an underlying stock trading, right around $50. We're gonna call it fictitious stock XYZ. You have the different strike prices, you have open interest and you have volume. Volume is very similar to the stock marketplace.
So you see X number of shares traded and an underlying like Apple. We're gonna look at Apple today as our real life example overall, and in the options trading world, that's also true. Volume is volume, you're seeing volume, but the one thing about the volume in the options world, you do not know if it's buying and selling, how it came into the marketplace. If it initiated a new position or not, volume does not tell you that, open interest does. So for example, on strike 35 here, we see that this option contract has not traded in this example here, but we do see that there are 12 contracts that have been opened.
Now realize this, that open interest means that you have a buyer and a seller of that option contract. Somebody sold the contract and somebody bought the contract. So it's no hint as to where the direction is on the marketplace, overall. Now you do not know with open interest, if it came to the marketplace as a buy or a sell, we do not know that, so some people might say that well, if I, as a public customer, put it in as a buy and the market maker took the opposite side of the trade, that that would be considered open interest that came to the marketplace as a purchase and that might be a bullish scenario, but there's no way of knowing that. So that's one of the misnomers that needs to be corrected as far as open interest is concerned.
Now, open interest is always quoted the next day. You do not get it as of today. You see the volume today, this number, if this was a live market, you'd be seeing volume changing, but open interest is tallied at the end of the day. And how that works is the Options Clearing Corporation will go in and see all the tickets that are marked to open and all the tickets that are marked to close and they will decide, okay, open interest yesterday in this example was, or volume yesterday was 304, but a lot of those were closing transactions and so the open interest the next day is 139, for example. So volume can be larger than open interest and if that's the case, you will see open interest go down the next day. See a lot of people think of option contracts as a hot potato, they don't understand that people are buying and closing them and that happens most often.
And that's what we saw on the previous slide, that 70% of the times, people close out that position before they even get to the exploration, but they kind of think of it as a hot potato. They're like, here you take it, I don't want it to expire in my hands. Here you take it, you do something with it.
If the options closed, that option contract ceases to exist. All right, so let's look at a real life example. And if you have any questions on this, if you have any questions, please put it in the chat box right now and I will try to address it before I move on and then we'll try to address the remaining questions at the end of the show, okay? So here we go, we're switching over to the option chains now. All right, so I'm gonna give you, I'm gonna look at two examples.
Right now we're seeing the Ally Invest Option Chain, we're looking at Apple. Now, I was gonna emphasize everything that we do here is not meant to be a recommendation. So we're just, we're looking at real life quotes and a lot of people know Apple of course, if you don't, you've been living under a rock for many years overall, but with that said, we're gonna look at this option chain. We highlighted some of the option chains on yesterday's show, but we see Apple right now is trading at 167. In the middle of our chain, we see the strike prices, on the left-hand side, we see the calls, on the right hand side we see the puts.
We see volume and we see open interest. And so right now on the most popular option contract, usually where you see the most volume are the option contracts that are at-the-money, right around where the strike price is very close to where the stock is trading and we see it at 167.50. So in this instance, we see the market is 4.45 by 4.50.
It means that if we were to buy this option contract, our buy price would be the ask if we bought it at market, if we were to sell the option contract, our sell price would be on the bid and these would be, so if I was buying and selling this option contract right away, I would actually lose money, right? 'Cause I'd be paying, the markets are moving right now, 4.45, and I'd be selling it at 4.40. And that's why we have market makers. The market makers are trying to buy on the bid and sell on the ask.
That's the general way that market makers, that's the benefit they have for making markets and being willing to take either side of the option trade. So totally, we have 26,800 call options that have traded, but the open interest is 12,379 contracts. Now, this number will not move until tomorrow. That open interest will not, there is more volume than there is open interest.
So this is definitely going to change tomorrow, but it's gonna be based off of the tickets that were marked to close, versus the tickets that were marked to open. Now, this is open interest in volume, the reason why I'm spending so much time on it, has a lot to do with the actual liquidity of the marketplace. We see a fairly tight market on the Apple option contracts. And we talked a lot extensively tomorrow or yesterday, I'm sorry, yesterday about liquidity. And the reason why they pick limited strike prices and sometimes in underlyings, they limit the number of explorations because they want to have volume, they want to have open interest.
The more people that are interested in the option contract, which is shown via the open interest, usually will mean that the tighter the marketplace will be. So I'm gonna run up and now that we've talked about Apple, a very liquid stock that has very liquid option contracts, and we're gonna look at a stock that's a well-known company also, but just does not have the option volume as much as Apple. Same type of stock as far as price, but we're looking here at 3M. And we have many different explorations to choose from in 3M, just like we do in Apple.
And we highlight here, we have weekly option contracts, option contracts that expire each and every week. And we're looking at the normal monthly option contract right now, the December 17th expiration. We're gonna stick on the call side and I'm gonna highlight here that we have on this option contract with the stock at 173.01. We'll highlight that today, it's up at one, almost three points.
We see that 3M, the 167.50 contract has a much wider bid-ask spread. If we are buying it, it's 7.45 and if we are selling it, it's 7.20.
Well, let's run over and look at the volume and open interest. So right now the contract basically doesn't exist because there is nobody that traded it. There is no open interest on this contract right now.
We do have one contract that traded, that means that somebody came to the marketplace, one person bought it and one person sold it. So tomorrow, ideally we should see this open interest number change, but it's gonna change overnight. And when you have lower volume and lower open interest, usually you're gonna end up with wider markets. And so to compare apples to apples, let's go and look at well, pardon the pun there, I didn't even realize that I did that. So compared to Apple, compared to Apple, 172.50, we see that we have about a 20 cent wide bid-ask spread between the sell price and the buy price of the marketplace overall.
So just an interesting example. You wanna dive into this a little bit more, please check out optionsplaybook.com in that one section, that I was looking at overall, I'm gonna go back to the presentation, but I'm gonna stop and I'm gonna take, I'm gonna look at a couple of questions. I see three or four questions, please make sure you put them in the chat box, I'm happy to address them. I'll continue on with the presentation here in just a minute, but right now, let's see what we have for questions.
So try to make them on the topic, on what we're talking about right now. What does it mean to be in or out-of-the-money when buying or selling call options? All right, so in-the-money means that we have real value. We're gonna talk about that value in just a second. We're gonna define a couple of terms that we didn't talk about yesterday. Yesterday's show we went into detail about being in or out-of-the-money. What it basically means is if I'm looking at a call option contract, I'll do it real quick like, and we see that this option, the underlying stock XYZ, which I'm highlighting on the screen right now is at around $50, 49.83 to be exact.
Well, that would mean that the 55 strike call or I'm sorry, the 45 strike call is in-the-money, why? Because I can exercise my right, buy stock at 45 and sell it on the real marketplace at 49.83, that would be considered an in-the-money call option because it has value, it has real value to be trading it overall. All right, next, if there is no volume, how is there open interest? Well, it's because it's a trailing number and that's a very good question overall, that comes from Natural Beauty. If it traded yesterday, like we saw in the 3M situation, we saw one contract trade today and we saw open interest at zero. Tomorrow there will be open interest, ideally, unless everything matches up.
But most of the time, because there was one contract traded today, tomorrow the open interest will be at least one. I mean, somebody bought it and somebody sold it. There's somebody on each side of that trade overall. So two people would be interested in that one example that we looked at on 3M, MMM is the symbol.
All right, so I guess in short, the answer to the question is, is because it's a lagging number. Volume is as of this second and open interest is calculated overnight. If a contract expires worthless, do you get to keep the stock? Not enough information, Natural Beauty on that one. I need to know what position you're talking about. If the contract expires worthless, am I selling a call? Am I selling a put, do I own a call or do I own a put? I need to know the scenario? Do I own the stock, do I not? There are a lot of different things that could go along with that, so I'll come back to that one at the very end of the show.
Feel free if you wanna adjust that question. Charlie asks, is it easier to buy a call or put, than selling color put since the seller doesn't have to worry as much about timing. It's not necessarily, the easiest thing to do in the options marketplace and I'm gonna highlight this when we get into strategies tomorrow, is just buy calls and buy puts, why? The risk is defined, it's defined to what you pay for that option contract and you have to be approved to do other things. If I'm selling a put for example, and I wanna buy the stock, if it goes lower. So I'm selling that put, targeting and a price below, getting paid for saying that I'll buy the stock if it comes down to a certain strike price, I have to be approved for that.
So to get into the mechanics, which today is all about. If I wanna trade options, I have to ask my broker for permission. I have to give them my background, my history, I have to allow the broker to do their due diligence. So overall in the options trading world, one of the easiest things to do is just buy a put and buy a call, not saying that because it's the easiest, it's the best, we'll address that a lot tomorrow.
But with that said, that's always the simplest thing to do because the risk is defined when I do that. Now, when I'm selling option contracts, I actually will probably end up doing a seminar called option strategies for the stock portfolio and how to use options to trade around stocks that you own, to minimize risk if you want, to maybe even add risk, to add leverage to your position overall. But that is a seminar in itself, so let's get through the basics before we get too far along. How do I make money if I close out my position? Well, hopefully, Sam, you closed out your position at a higher price. So for example, if we looked at the Apple option contract, I'm not gonna run back to the change just yet, I'm not gonna go there just yet.
But if on the Apple option contract, the stock was at, or the option at-the-money was trading for $4 and 45 cents. If Apple goes up today and it continues on up, and let's say it goes up three or four points, well, guess what, your option contracts should also go up. When you sell it, you can make that money, you can make that profitability on it. That's what the listed market place has done to the options world. Prior to the listed market place, it was very hard to buy an at-the-money call option on Apple, have Apple go up in price and you're able to profit from it because it's made the markets liquid enough that you can do that.
And also, I always like to say the opposites I do, if we went down, we paid 4.45 for it, it went down and all of a sudden we see it trading at 3.45, well, I'm like, oh, I guess I was wrong on my forecast, I can close it and get out too. So the liquidity is there no matter if I am up on the trade or if I am down on the trade overall. All right, so let's get back to the presentation. Open interest, very, very important topic when you're looking at an option chain to understand it.
Now, I just wanna emphasize that it doesn't have any regard to direction. Open interest is not something a lot of people try to manipulate the data to say, this means that the market is going up or the market is going down. Open interest overall is just telling you the number of people that are interested in that option contract. And once again, if nobody ever trades the option, the quote is just an advertisement. If they don't trade it, that option doesn't exist. Do I want open interest? Yes, I do.
If I'm trading options, I want open interest and some option contracts on some underlyings might not really be feasible to trade because there's not enough volume to make the markets fairly liquid and overall you're paying a lot by buying and selling an option contract because of the difference between the bid and ask spreads, so I want open interest. Would I rather trade options in Apple than 3M? Yes, but has nothing to do with the fundamentals of the company, has everything to do with the liquidity of the marketplace overall. And that is shown by looking at open interest on the option contracts that I'm trading overall. Options priced accordingly. I figured that I needed a break in the slides to say, we're gonna switch from the basics and now we're gonna get into the mechanics. This is the most step in laying the foundation for your option trading.
We went through the vernacular, we continued with the vernacular, now we're gonna talk about option pricing. And in order to do that, to answer a question from somebody that may not have seen the 101 show, which was yesterday, we're gonna talk about intrinsic value and time value. We defined this, we called it in-the-money and out-of-the-money overall, but there's terms that go with it. If an option contract is in-the-money, it actually has intrinsic value, real value. It's worth something because I can exercise my right and either buy or sell the stock at an advantageous price, considering where the marketplace is at. So we're gonna focus on calls, basic seminar, calls are easy to understand and puts, but both of these concepts apply no matter where, these terms apply to both puts and calls.
But here's our example. Strike is 70, the stock price is 75. We look at it, we see that this strike call is trading at $6. The stock price is 75, the strike price is 70.
So in this instance, we can exercise our right and we'd be buying stock at 70, right? That's what the call is, the right to call stock away from someone at 70. We could go to the marketplace and we could sell it at 75. In this instance, there's still some time value remaining, so we actually see the option trading for six. Well, $5 of that is in-the-money, that's real value, also called intrinsic value and that leaves $1 worth of time value overall.
So this is an in-the-money option contract, it has intrinsic value and it has time value. Now, if we go to a different scenario, let's move the stock price. We had the stock price in our first example at 75, let's now make it at 65, same option contract, the 70 strike call, we see that's trading for a dollar.
All right, a lot less, why? Well, you're not getting as good of an option contract because you don't have real value and so in my mind, you're speculating more that the stock might be able to get to that price. So if I'm doing this, it's gonna be cheap and it's gonna be cheap relative because it's not in-the-money, there's no intrinsic value. So if you take the stock price at 65, you minus the strike price in this instance, your intrinsic value is minus five, but it can't be minus, so we just would say that it's zero. But in this instance, if I do this scenario, I don't wanna exercise my call option.
If I exercise, I'm buying stock at 70, why would I do that when I can buy it in a real marketplace at 65? So this option prices all time value. We have $1 worth of time value on that trade. So here's the question, why is it $1? Why is this option contract priced at a dollar and what was the basis that was behind it? So in order to do that, we're gonna go back to the insurance world. We talked heavily yesterday that there are a lot of synergies between pricing an option contract and pricing and insurance contract.
So the Black-Scholes pricing model is a paper that was written the year the Chicago Board Options Exchange opened their doors, Fischer Black and Myron Scholes wrote a paper. They received a Nobel Prize for Economics on it overall, but it helped solidify the pricing of an option contract. And all of these variables that you see in this option contract, were all in that pricing model. And guess where they got that model from, or in general were a lot of the concepts of that model came from, an insurance policy. So let's talk about an insurance policy.
First of all, you get paid well for figuring out insurance policies. Actuaries have many, they pass many different tests about statistics to work for insurance companies, and they're a lot of times the highest paid people within that firm and they're all trying to figure out what's the risk of this person in the example of car insurance, actually getting in an accident or the risk of your house, getting blown away by a hurricane overall. So they're trying to use math to say in all of these different scenarios, if we take it as an aggregate as a whole, how often does the worst case scenario happen? So let's talk about car insurance.
All right, if I'm going to price a car insurance policy, I need to know the price of the asset. Is it a Chevy Cavalier or is it a Bentley? The value of that underlying is gonna be very important in pricing that car insurance policy. The deductible, very rarely do people buy the zero deductible car insurance, they get to take on some risk. And if they take on a little bit of risk, well, that greatly reduces the price of their insurance policy.
So do you want the $500 deductible, do you want the $1,000 deductible? And as mom always said, time is money. If you buy it on a six month basis, it's going to be cheaper than on a one-year basis, that's very straightforward, but there's a time component that goes into the option to the insurance contract overall. Now this one might be, this is not as intuitive, but there are carry costs. When you pay for your insurance policy, when do you pay for it? Do you pay for it at the beginning of the term or do you pay for it at the end of the term? You pay for it up front, right? The insurance company, doesn't let you go the entire six months of that policy and then say, okay, now it's time for you to pay for it. Well, what does that mean? That's an advantage to the insurance company, because that also means that they have your money and over the life of the policy, they can invest that, they can earn interest on it.
And in a utopian world, that means that if they do very well on earn interest, they will give you a discount on your next six month policy. That's the concept of insurance, they don't always do that overall, but we did see that a little bit during the pandemic. We did have some insurance companies come out and give rebates because nobody was driving. Everybody was working from home, so through that stent, some insurance companies actually did step up and actually give rebates on some of the policies, I digress a little bit here. But now we get to the one thing that's the most important thing and the hardest thing to calculate, the level of risk. Is this person, let's talk about a male 35 years old, the teacher drives a Caravan, father of four.
Or are they're the same age, just got a Navy Seals training. So driving the car off the cliff might actually be a training exercise overall. If I look at those two scenarios, they're totally different profiles for that person. They're trying to adjust that level of risk by looking at that profile and looking at similar profiles, to come up with a number, to try to price and give you a premium for your insurance policy. Guess what everything that's in here is also in the option contract.
Once I put all that data in, I get a price. I say, here's your premium, you got to pay your insurance premium overall. We go over to the other side and we look at the option contract. We got the stock price, strike price, and the expiration date. Obviously all of these go right along in the hand with the price of the asset deductible and the time.
Stock price, if we think of options as they were first intended, which I mentioned a lot yesterday, as pure insurance contracts, the most pure insurance contract would be, I own 100 shares of Apple, I am going to buy a put that will allow me to put stock to somebody at a lower price than where the market is currently trading, that's called a protective put. We'll talk a little bit about that tomorrow, but when I do that, I'm fixating a sell price. Now I have to pay for that, that's not free in order to say that if the stock goes down, I wanna be able to sell it, but that person that sells me that option contract is taking on the obligation to take the other side of the trade, if I want to sell my 100 shares of Apple that I own. I'm emphasizing, I own 100 shares of Apple, I buy one put in that scenario. Just like on the insurance policy, the person that sells you that car insurance policy, they're saying, if you drive it into a tree, we're gonna give you a new car. And that scenario, I guess, Apple going down in price would be similar to driving your car into a tree.
But overall, that's the concept. Okay, strike price. Well, if Apple right now, I think it was trading at 167, let's say I buy the 165 strike put. That means if it goes down two points, I can take that stock, and it goes to 163 and put it to somebody at 165. So in that scenario, I'm taking the $2 deductible. I'm saying from 167 down to 165, I don't have any coverage, but if it continues on down, prior to that expiration date, I can take my 100 shares and put it to somebody at the higher price, which would be 165.
Now interest rates and dividends, a little bit harder to grasp this concept, but that's what carry costs are. In the car world, you don't drive your Ford F-150 around for three months and they say, thanks for driving our car, here's a dividend, but their stock might. And other stocks might say, well, if the company is doing well, we're gonna pay you a dividend. So you have interest rates, you got to pay for that option upfront that's carry costs. The seller gets the benefit of getting that premium upfront, but also stocks pay dividends.
So that component is in the price of the option contract. And it's always upfront just realize that, that they know the dividend is coming, they adjust their price accordingly to the option contract. And then instead of risk, we call it volatility. Would I be a little bit more nervous to sell put options in a stock like Apple or 3M? How do we adjust that risk? And the way that we look at it is what is that volatility number? How volatile is the underlying stock day in and day out? Not saying that the stock price is going up or going down, I'm just saying every day, what is the deviation? What is the standard deviation? Does a stock move five points every day in general or does it move 10 points? Does the stock, so the more volatile the day in and day out movements are, the more risky it is to the person that's selling that option contract.
If I'm selling options, I want some predictability in what the underlying is gonna do overall. But the marketplace is always trying to figure out what this number should be, just like trying to figure out the level of risk and between the insurance companies. What happens in the insurance companies? Well, then you have Allstate and Geico.
Allstate is coming up with a calculation saying this profile is less risky than that profile. Allstate might have a different opinion on that based off of their model. Guess what market-makers on the floor are doing? Exactly that, they're trying to get the volatility right and then they're trying to capture the difference between the bid-ask spreads and if they can get the volatility right, and they're saying, we're selling it at the right volatility, they can adjust their positions and that's how they make money, that's what their goals are. They're trying to make pennies on the marketplace overall, but they're trying to do it hundreds of thousands of times, over the life of that option contract in general. So we went into volatility. So this is we're coming to the end here and I'm sure that that generated a lot of questions.
And one of the biggest things overall, I'm gonna scroll down on the questions over here. One of the biggest things overall that we see, that didn't work the way I thought it was going to, is that if we look at the price of an option contract, a lot of times that component of it, people are scared to dip their toe and they're like, I'm a basic option trader, why do I need to know that? The biggest reason why you need to know that is because you're gonna be trading this and it's much different than trading stock. So you need to know the basis behind it before you start trading options. And so I keep emphasizing the fundamentals, the foundation before you get into actually trading strategies is so important because of this. And I know this will be on demand, you can go back and you can look at it and you can see where you can, if this was a little bit confusing, you can watch it again, but let's soldier on here.
Types of volatility. So I'm showing a slide on types of volatility and probability. So we have historical volatility, that's important to pricing an option. I want to know what the stock has done previously.
And the textbook definition would be a measurement, or I should say the Option textbook definition would be a measurement of the actual observed volatility of a specific stock, over a given period of time. It's normally quoted on an annualized basis. So whenever I'm looking at volatilities in general, it could be historical or what we're gonna define here implied, it's usually quoted on an annualized basis so that you're looking at apples to apples, right? I wanna know what the ball is for the stock historically on an annualized basis and what the implied volatility for the option contract is on an annualized basis. So implied volatility does not exist unless the stock trades options, It's used by calculating it using a pricing model. And it is an estimate of the option's future volatility, as predicted or implied by the option's current market value.
So I'm gonna jump back one slide, and I'm gonna say, if we look at everything on these components of the option contract, all these different components are very easy to find, right? I can get interest rates, you just need the short-term interest rate, expiration date, I might have to take my shoes off, but I can usually count back to where the expiration date is. Strike price is very simple and obviously the stock price, you just get a quote on the stock. This is what's a mystery, volatility, right? Same like everything over here in this insurance policy, the price of the option contract, guess what? I can also get a quote on the price, we just showed you that on Apple and on 3M, it's easy to get a quote. Well, if I know all of these things, I can solve for volatility and as retail clients, that's what we would do. We're not trying to forecast volatility, but we'd like to know what the marketplace is implying the volatility to be right now.
And now that's based off of all the activity, what people that are buying and selling option contracts and people that are trying to make markets in it and trying to keep the market feasible overall for them to be able to trade and try to make money overall on those positions, by buying on the bid and selling on the ask. That's what market makers do overall. All right, so that's how I would find that implied volatility. And I highlighted here in that second section, second sentence of the definition. Now I bring this up because here is the most important part and I'm gonna have to switch it up here fairly quick.
I'm getting a little bit long-winded. That implied volatility tells you something about probability. And this is gonna set the ground work for tomorrow's outlook at strategies. And we're gonna look at very basic strategies to start with, but probability in a textbook is the extent to which something is probable, the likelihood of something happening or being the case.
Now probability goes hand in hand with implied volatility regarding the potential movement of the stock price before the options expiration. So for example, I might even actually be able to say, implied probability, that's not a term in the options world, but I could actually take volatility and replace it with probability, because what I'm trying to say by they go hand in hand is that they're very similar. If you wanna know the probability of a stock reaching a strike, you need to know what the implied volatility is overall.
So let's go through a scenario. I'm gonna ask you a quiz overall. So here's a quiz, theoretical pricing. Now we're in a theoretical world, we're talking about stock XYZ again, but I did use a theoretical options pricing calculator to come up with this scenario. And think about option pricing as probability of an event. What's the probability of the stock getting to that strike.
That means something to me if I'm gonna make markets in that option contract. What's the probability of that option getting to that strike? Now, I'm gonna give you a scenario and I want you all to think about it. I'm not gonna give you the answer right away, I want you all to think about it and put your answers in the chat box if you would like overall, but this is your first time.
And if you're out there and you're listening to this event, you probably haven't traded an option before because like I said, this is very basic overall, but this is your first time trading an option. You see the stock at 70, you buy the 75 strike call option. It's trading for $1, that means it's $100 plus commission to buy that option contract. It is a 90-day option contract, we're just gonna go by days, we're not gonna talk about months, 90-day option contract. The stock is at 70, the 75 strike call is one.
Let's fast forward, follow the arrows over and go to 45 days. Oh my gosh, you were right on your forecast, the underlying stock went to 72.50. We have the 75 strike call option is trading at what? What is it trading at? What's the answer? What do you think it is? Now, there are no incorrect answers here on YouTube, in the real marketplace there are incorrect answers. So if you wanna participate, this now is the time.
What do you think that number would be? Now, I'm gonna emphasize if there are some more advanced traders out there, volatility didn't change, right? We're not taking out that volatility component. We're just saying that the stock price moved in that pricing calculator, stock price moved, and the days to the expiration moved. What is the 75 strike call trading for? (vocalizing) $1, yup, that's what it's trading for overall.
Why is it $1? Well, if you did put this in the pricing calculator and there are many different pricing calculators available online, and you keep all these variables the same, you will see that the probability didn't change. And this is a lesson just about in general, about buying out-of-the-money option contracts. I also in "The Options Playbook," I have the top five mistakes that option traders make, beginning option traders 'cause I do get a lot of flack on this because people say, "I bought all the money on the option "and I've done really well." Well, beginning option traders just don't quite understand why they might wanna buy a $6 option contract, like our in-the-money example, versus a $1 option contract. And the problem with a $1 option contract is if you don't think that stocks gonna get to that strike, if you don't think it's gonna go up to 75 by that expiration date, it's hard to make money on that option if it does not do that overall.
So here we are correct on our forecast, it moved to 72.50. The option went from a dollar to $1, why? We went up, we went half the distance to the strike in half the time. The probability of a getting to 75 didn't change. Guess what, the option price didn't change either overall. We bought the in-the-money option contract, we're already in-the-money, and as we go up, we're gonna gain intrinsic value, right? It's no longer just time value, it's no longer just speculating on if the stock is gonna get to that strike price by that expiration date. So that in-the-money option contract would have done better in this example, overall, you would have had to pay a lot more for it, but it would have.
Now if the stock went to 80, which one would I'd rather own? Well, I'd rather have one the cheaper one because it did get in-the-money and it did reward me accordingly with intrinsic value. So it's just a different component, we're gonna talk a lot about that tomorrow, I don't want to digress overall. So let's finish this and then I'll get to a couple of questions, I'll try to leave five minutes for questions. So there's one way that we can look at, I'm gonna give you a theoretical number that can help you with the pricing of an option, it's called delta.
Don't get scared by that, you saw it on our option chains. If you go back and you scroll back when I was looking at an open interest, it's on the Ally Invest Option Chains on the put side and on the call side, but it's the theoretical options price that will change for a corresponding one point change in the price of the underlying. So if I look at a delta, it tells me approximately how my option should move relative to the stock price movement. It's obviously a very important number. So I wanna look at that and the reason why I say this is I want you to develop realistic expectations before you trade an option contract.
I want you to kind of have a feel for what that option might move. If you got that question wrong that we talked about, you shouldn't be trading options, right? Because you should understand how this option moves and why it's moving the way that it is, delta will help you with that. Now the non-textbook definition is that it's the probability of the option being in-the-money on exploration, obviously implied volatility has something to do with it. The more volatile it is, the chance of it making in our example of point move is higher, but then that means you're probably gonna have to pay more for it, right? Because volatility has gone up and for people to make markets in it, they are gonna wanna get paid more.
If they're selling those option contracts and buying them overall, I want to buy it, I want it to move, but here's an example. Stocks at 50, strike is 50, three month call option, stock goes from 50 to 51. That's what your option should go up about 50 cents. That means that the delta was 50.
You would have looked at that at-the-money option contract, the delta would be about 50. Stock goes from 51 to 52, guess what, you pick up delta, it actually increases in value because you get intrinsic value in this instance, and then it goes from 3.50 to 4.10, it goes up 60 cents. Delta would've changed accordingly. It's a dynamic number as you go in and out-of-the-money. But the reason why I put the non-textbook definition in here is that at-the-money option contracts, what are the odds of it being 1 cent in-the-money on exploration? I don't know exactly, but if it takes up $1, now it's in-the-money, it takes down $1, it's out-of-the-money.
So most at-the-money option contracts, either on the call side or on the put side, are gonna have a delta of somewhere close to 50. And as we get deeper and deeper in-the-money, delta is gonna increase. And as we get further and further out-of-the-money, delta is gonna decrease overall.
All along there's a time component that's being factored in. So I don't want this to scare you, I want you to be like, oh, thank goodness, there's something that can give me a hint as to how my option contracts could move. As opposed to saying, oh, "This is just way too beyond me. "I just wanted to buy an out-of-the-money call "or an out-of-the-money put, "what's Brian talking about overall?" Develop realistic expectations before you start trading options overall. Top 10 Mistakes article, I referenced it. One of the biggest mistakes and it's the most widely read of my white papers that I wrote way back in the day, is you just start by buying out-of-the-money contracts.
We're gonna address that tomorrow in detail, but that's one of the, well, in "The Options Playbook," it's actually the top five mistakes, it's under the Management tab. I did write an article with 10, I added five more to it. then also, how do I get started? What strategies should I consider when beginning options? And I'm gonna get into that tomorrow when we get into strategies, Options 301. Okay, I got a few minutes for questions. Once again, I'm a little bit long-winded so let's get out of the PowerPoint and I will go back over to the questions and answers here.
Oh, cool, quite a bit of them. All right, I'll go as many as I can. How do I determine the most advantageous strike price and date to buy a call or a put? That's what we went through, we talked a lot about it.
Come back tomorrow, Lewis, I anticipated this question and I'm gonna go into detail a lot about buying options. Not that I think it's the best strategy to begin with, I just want to address where most beginning option traders mind goes to. So we were gonna talking about that a lot tomorrow. Larry, can you clarify open interest on the option chains as it relates to the call side and the put side specifically. Is the OI specific to the call put, call and put, and if so, why, why didn't they create an order slash volume? Yeah, it is specific in that instance where we looked at 3M, that was for that one call option.
And if you went to the put side on that same strike line, same expiration, that open interest would be for that put option. And the main reason why is some people wanna buy puts, some people wanna buy calls. So once again, the quote is an advertisement. If nobody trades it, there will not be any open interest. It's kind of like if a tree falls in the woods and nobody hears it fall, does it actually fall overall? Well in the options world, if nobody trades that quoted option contract, ideally it's not a contract, it doesn't exist overall.
It doesn't matter if it's a call side or the put side. The biggest thing about open interest is that you like it as an option trader, you want more open interest than not. No regard to direction, don't try to make it that, it's all about liquidity.
The more open interest, the more volume that trades day in and day out, the more liquid the marketplace will be. And usually that will lead to tighter bid-ask spreads. Volatility can affect that, it's really volatile, sometimes bid-ask spreads will widen a little bit, but that's just because I got to make a market in it. And I'm scared if I'm trading something like one of the meme stocks that I will not mention any specific names overall, but if you know what I mean by the meme stocks, when they went crazy, would you have liked to been on the floor of the Chicago Board Options Exchange, making markets in it, hefting to take the other side of the trade as those orders came in, right? Think about that concept overall. That's true implied volatility. Do I understand, okay, can you clarify open interest? Okay, right here.
Roger, I think we're gonna be a couple of minutes over, Roger I'm gonna leave you with the last question. Here we go, do I understand that if you buy a call, you have a call buy. So you bought a call. Do I understand that if you bought a call, you can just close out the option contract and take the premium profit and never exercise the contract to buy the stock. Ding, ding, ding, ding, ding, we learned something today, that's exactly it and it's the most common thing that's done.
70% of the time option contracts get closed on the marketplace overall. All right, great one to finish with. I'm going to go all the way back. Well, I'm gonna let you know that my name is Brian Overby. I am the Senior Options Analyst at Ally Invest. If you'd like to sign up for all my courses, you can actually go to ally.com/investeducation,
which is highlighted here on the screen. That is actually an email list and you'll get alerts for everything that I do within Ally Invest. Almost all of it is free, you don't really have to be behind a sign-on overall to view any of it. You can follow me on Twitter, I'll usually tweet about an educational event more often than not, @BrianOverby, very simple. And obviously "The Options Playbook," go to options playbook.com. We do sell the book on Amazon, but we're not in the business of selling books, we're in the business of educating investors.
And that's why I wrote the book to start with overall. And if you'd like to learn more, either go to optionsplaybook.com, or like I said, we do sell the book on Amazon overall. That's it, hopefully we'll see you tomorrow for Options 301. If you'd like to, you can actually just click Subscribe, and ring the bell, and we'll give you an alert for everything that we do here on the Ally YouTube channel. And if not, hopefully I'll see you tomorrow for Options 301, thanks for coming everyone.
2021-12-04 23:17
