Options Trading Basics : Trading as a Business Video 2 Part 4

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The problem with people who are speculating using options – and I’m talking primarily about people who buy options, to try to profit from the stock going up, or the stock going down. We haven’t talked about puts yet.

Puts are actually options that you can actually purchase, if you believe IBM stock is going down. It works the same ways as calls. The only difference is, when you purchase a put option, you believe that the stock is going down. If you were to purchase the $125 strike price option on IBM, and you purchased one put for $3.60 – if IBM fell $5, then this whole blue-gray “in the money” options would shift up $5. If you were to sell it, you would have a profit of $6.60, minus the $3.60 you purchased it for. You would make a profit of $3.

The problem with speculation like this is that, what happens if you’re wrong? Let’s say you purchased this option for $3.60. The stock moved up $5. The guy who bought the call option just made $3 profit, but what happened to your profit?

This will all shift down. If the price of IBM is at $130, then your option that you purchased for $360, you’re only going to be able to sell for $1.55. Now you’ve lost $2.05.

How come you didn’t lose as much as you would have made if the price went up? There’s lots of different reasons for that. Number one is – if the stock did move up to $120, the probability that it would stay a little bit lower, is higher than if it went up $5.

In other words, if you purchased the put option at $3.60, the stock dropped $5. Now your option is worth $6.60, if you were to sell it in the market. The reason that it went up $3 is because now it’s called “in the money.” In other words, the strike price of $125 is now $5 higher than the actual stock price.

The market makers consider that a higher probability, that it will stay, it will expire, “in the money.” That the option will expire at a point where it is profitable. However, as you can see, the lower you go, the less value these options have. The $120 option, which is about 5 points “out of the money” – which is about $5 out of the money – only has a value of $1.65.

Why does it have a lower value than the 125 option? Because the probabilities that the stock is going to be trading at 120 dollars when it’s currently at 124 on the 3rd week of May, when this option expires, is less.

We can actually determine that. There’s lots of information that you can get on each one of these individual options, including volume – how many actual contracts were traded on that particular strike price, during the day. This is the actual volume of trading that took place yesterday, on IBM stock.

You can see here that the May 120 calls, 2,247 contracts were traded. The May 125 calls, 7,104 contracts were traded. The May 130s – 9,557 contracts were traded. You can see that the majority of people will trade right around these “at the money” strike prices.

You can also get some other information about these options. Including the probability of expiring. See, what happens is, when you purchase an option that’s “in the money,” you have a much greater – we’re looking at this column right here, the probability of expiration.

You have a much greater probability that that option will remain profitable and of some value the third Friday of the month, based on its current stock price. As you move out of the money – the market makers are saying, “You know what? This $105 option only has a 3.91% chance of being worth anything at all by the third week of May.”

Doesn’t that make sense? It’s currently about $20 away from the current price of the market. The market makers are saying, “Look, we’re only going to give that a 4% chance of actually being worth anything.”

That’s why it’s so cheap. It’s a very cheap option. If you were to purchase that for 20 cents, and IBM were to take a dive, and fall below $105, or even get to the point where it’s “at the money” – the “at the money” options are selling for $1.65. Your option that you purchased for 20 cents – we can see that a 20 cent option is only $22.95 – is now going to be worth $1.65, or $165.

You can see that you can buy an option for 20 cents. In real terms, it’s 20 dollars, because you have to multiply it to a hundred to get your real cost. It can easily be worth $1.65, or $165, which is an incredible return on investment. There are a lot of people who speculate that IBM may drop that far. That’s why they buy these options.

It doesn’t have a very good chance of being worth anything at all. IBM stock does fluctuate. There’s no doubt about that. In fact, if we take a look at a chart of IBM…

You can see that IBM, back in January, around the 11th, IBM was selling at about 98 dollars. If you thought the potential for IBM was to go up in price, you could have purchased an “at the money” call option on IBM when it was right around 98 dollars, probably around the current May options are, so about – let’s see what they were selling for – $2.80.

Let’s say you bought a call option for $2.80. From that time until the 3rd week of February, in the 3rd week of February, IBM was trading for around $106. The difference between $98 and $106 is approximately $8. IBM rose in price by 8 dollars. What would happen to that contract, if you bought it for $2.80 and it went up $8?

It’s going to be close to 10 dollars in price, because it’s gone up almost 10 dollars. It’s going to be worth 7 or 8 dollars, minus the $2.80 that you paid for it. You’re going to make a profit of about 5 dollars.

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