There are certain pieces of data and intricacies associated with options that you should learn about before you decide to invest. These greatly affect the value of an option and learning about them will give you a better understanding of how options operate and why they can be more lucrative than stocks. We will discuss four major points here.....
1) the spread
2) the delta
3) declining option value
4) open interest
The Spread
The current price of an option is simply the price at which the last trade was executed. In reality, however, you are unlikely to be able to buy or sell an option at the current price. The same holds true with stocks. If a stock is priced at $50, it just means that the last trade was at $50.
A stock price will have something called a bid and an ask price. Generally speaking, a bid price is the price at which you'd be able to sell the stock, whereas the ask price is the price at which you'd buy. If a stock is at $50.00, the bid would probably be around $49.98 and the ask price about $50.02. So if you bought shares at $50.02, in real time you would already be down 4 cents per share, since you could only sell at $49.98 at that particularly moment in time, not including commission charges. Only traders who trade an outrageous number of shares would typically be able to come down from $50.02 to probably $50.00 or $49.98. For regular traders, use the bid and ask prices as selling and buying points, respectively.
The difference between the ask and bid price is called the spread. In order to become profitable, you will eventually have to cover the spread in order to offset the initial loss.
Options have spreads as well, but they tend to be larger. The is one of the drawbacks of options trading. A spread normally ranges from 10 cents to 20 cents. If an option is priced at $3.50, expect a bid to be at $3.40 and an ask to be at $3.60. This is a 20 cent spread.
Shaving the Spread
Even though the spreads for options are wider than those for stocks, there is some good news. You can perform what is called "shaving the spread." The execution of an options trade is nowhere near as quick as for a stock trade. An options trade can easily take a minute, whereas a stock trade can take three seconds, maybe less. Because of this, you can actually set some demands for your price.
Let's take the example provided. If an option is at $3.50 and you want to sell, you'd typically have to follow the bid price. In this case, $3.40. But when you put your order in, you can set the limit order at $3.45, thereby "shaving the spread" by 5 cents. It may take a little bit longer than if you offered to sell at $3.40, but you may find the extra 5 cents to be worth it. This may not sound like much, but if it's 100 contracts that you sold then that's $5 more. If it's 200, then $10, 300 then $15, etc. In time, such minor differences can accumulate into a substantial amount. In this example, you may even be able to "shave the spread" by 10 cents.
As a guideline, you should try to shave no more than one-half of the spread. So don't try to shave more than 10 cents if the spread is 20 cents, or 5 cents if the spread is 10 cents.
The Delta
If you've studied advanced mathematics at all, you'd know that delta means "change in." That is, how much the value of something will change given that a specific event occurs.
Options have deltas as well. In fact, the delta is an important component when deciding to invest in any option. Many options quotes that you see will refer to deltas as theoretical values. This may be the case, since there's literally a lot of calculus that goes behind calculating the delta. Such math will not be discussed here, but you should treat the delta as if it wasn't theoretical. Treat it as a "profit calculator."
Let's say you own an option that's currently at $4.00. The delta is simply the amount the stock will rise if the underlying stock rises by $1. Let's say the delta for this option is .60.
If the underlying stock is at $40.00 before trading, and sometime during the day it hits $41.00, then the option will rise by the delta value. In this case the option will go from $4.00 to $4.60. That's a 15 percent return - not bad!!
The highest deltas ever go for long call options is .99. For long put options, it's 1.01.
The Law of the Shifting Delta
The delta shifts along with the stock price. This is a huge advantage for options traders. In the example above, you would think that if the stock hit $42.00 then the option would rise by two-times-delta, or $1.20, to $5.20. In fact, this is not the case. Once the stock rises, the delta rises along with it. If it hit $41.00, the delta would actually go higher than .60. As an estimate, it would be around .70. So if the stock went from $41.00 to $42.00, the option would go from $4.60 to $5.30. If the stock keeps rising, the delta will go all the way up to .99, which is the peak for any long call option (again, 1.01 for long put options).
Even better, in the unfortunate event that a stock actually loses value while you own a call option, the delta doesn't imply that the option will go down by the same amount as it goes up. If it goes from $40.00 to $39.00, the option will not go down by delta. It will go down, but fortunately it goes down by less than the delta value. So you wouldn't be losing 60 cents per option contract. You'd probably lose only around 50 cents.
Think about this for a second. The delta accelerates even more when you're actually earning money, but your losses slow down when the stock loses value!! Therefore, you could say that the reward is greater than the risk. That is, you get more "bang for your buck" with options trading.
So when considering the delta when you initially buy an option, and knowing that it actually increases as the stock gains value, a good "sweet spot" for a delta would be .75 and above.
Declining Option Value
As mentioned on another page on this site, options have a declining time value. The older they become, the more this time value will take its toll. Of course, an option that's performing well can easily offset this decrease and then some, but you should just know that "gravity," so to speak, is pulling down on the value of the option. The calculation of this time value is rather complicated, but as a trader the most important thing to know is that this time value accelerates 14 days within the expiration date of an option. The force of this "gravity" gets stronger, eventually bringing the option down to zero-value on its expiration date.
If you ever find yourself within this 14-day window and you realize that time isn't on your side, you should use your best judgment. The time value will pull the value of the option down, but performance can still help keep it afloat. Do what you think will offset your losses the most. But remember, always be sure to get something for your options rather than having them expire!! Something is always better than nothing, even if it isn't as much as you wanted it to be!
Open Interest
An option's open interest refers to the number of contract lots currently being traded on an option. Options that have been exercised or closed are not included in the tabulation. Open interest is somewhat similar to the volume of a stock, but for the sake of options trading it is much more important.
Here's why. Options trading tends to be a zero sum game. That is, whatever is sold by one individual there must be a buyer on the other side. If you own some option contracts and there is hardly any open interest, so to speak, it becomes less likely that you will be able to sell your contracts back to the options market. It is not uncommon for an option to have an open interest of zero. You should avoid such options at all costs. If you happen to buy some contracts, you will be the only person engaged in that option and there would be nobody on the other end to buy it from you. You'd then be stuck "eating" what you bought. You definitely want some open interest, but you don't want to be the open interest.
As a general rule, only trade options with an open interest of at least 100. An open interest of at least 1,000 would be better. And try to never hold more than 10% of the open interest. The more open interest, the more liquidity an option has.
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