Testimonials

February 9, 2012

Moneyness and AAPL

Filed under: Options Education — Tags: , , , , , , , , — Dan Passarelli @ 10:47 am

Moneyness isn’t a word, is it? It won’t be found on spell-check, but moneyness is a very important term when it comes to options. There are three degrees, if you will, of moneyness for an option, at-the-money (ATM), in-the-money (ITM) and out-of-the-money (OTM). Let’s take a look at each of these terms, using tech behemoth Apple (AAPL) as an example. At the time of writing, Apple was hovering around the $490 level, so let’s define the moneyness of Apple options using $490 as the price.

At-the-Money
An at-the-money AAPL option is a call or a put option that has a strike price about equal to $490. The ATM options (in Apple’s case the 490-strike put or call) have only time value (a factor that decreases as the option’s expiration date approaches, also referred to as time decay). These options are greatly influenced by the underlying stock’s volatility and the passage of time.

In-the-Money
An option that is in-the-money is one that has intrinsic value. A call option is ITM if the strike price is below the underlying stock’s current trading price. In the case of AAPL, ITM options include the 485 strike and every strike below that. One will notice that option positions that are deeper ITM have higher premiums. In fact, the further in-the-money, the deeper the premium.

A put option is considered ITM when the strike price is above the current trading price of the underlying. For our example, an ITM AAPL put carries a strike price of 495 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, an AAPL 500 put has a premium of $12.20 compared to a price of $4.80 for a 485 put.

If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned a AAPL 485 call and AAPL closed at $490 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of AAPL at $485 a share.

Out-of-the-Money
An option is out-of-the-money when it has no intrinsic value. Calls are OTM when their strike price is higher than the market price of the underlying, and puts are OTM when their strike price is lower than the stock’s current market value. Since the OTM option has no intrinsic value, it holds only time value. OTM options are cheaper than ITM options because there is a greater likelihood of them expiring worthless.

If this is the case, why purchase OTM options? If you have little investing capital, an OTM option carries a lower premium; but you are paying less because there is a higher possibility that the option expires worthless. OTM options are attractive because OTM calls can see their premium increase quickly. Of course, OTM options could see their premium decrease quickly as well. Remember that OTM options can log the highest percentage gain on the same move in the underlying, in comparison to ATM or ITM options.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 19, 2012

Bull Call Spread vs. Purchasing a Call

Filed under: Options Education — Tags: , , , , , , , — Dan Passarelli @ 10:38 am

Bull Call Spread vs. Purchasing a Call
Let’s say that you have a moderately bullish bias toward a stock and the overall market is slightly bullish. Is there a way that you can take advantage of this investing scenario while limiting risk? Certainly, there are a few. One that is often superior to the rest is the bull call spread.

Definition
When executing a bull call, you purchase call options at one strike and sell the same number of calls on the same company at a higher strike with the same expiration date. Let’s use Apple Inc. (AAPL) which is currently trading around $430 as an example. In this case you would purchase February calls at the 430 at-the-money strike at the ask price of $14.45. You would then sell the same number of February calls with a higher strike price, in this case 450 at the bid, $6.25.

The Math
Your maximum profit in the bull call spread is limited, you can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that you purchased one February 430 call and sold one February 450 call resulting in a net debit of $8.20 (that’s $14.45 – $6.25). The difference in the strike prices is $20 (450 – 430). You, therefore, subtract 8.20 from 20 to end up with a maximum profit of $11.80 per contract. So, if you traded 10 contracts, you could make $11,800.

Although you limited your upside, you also limited the downside to the net debit of $8.20 per contract. To simply breakeven, the stock would have to trade at $438.20 (the strike price of the purchased call (430) plus net debit ($8.20)).

Advantage versus Purchasing a Call
When trading the long call, your downside is limited to the net premium paid. If you simply purchased the at-the-money February 430 call you would have paid 14.45. The potential loss is, therefore, greater when employing a call-buying strategy. If you move to a call with a longer time frame to expiration, you would pay even more for the option. This would also increase your potential loss per option.

Conclusion
By implementing a bull call spread, you have hedged your bets – limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no fool-proof ways to make money by using options. However, knowing your strategy is a good way to limit losses.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring