Boca_Bobby Basics

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Options Talk-N-Trade (Options TNT) #2

In today’s chat we need to discuss a little more about those out-of-pocket costs for the contracts. To do this we’re going to need to talk a little math. I hope this doesn’t scare too many folks. But we really need to change the way we think. Many new option traders are recent “penny traders” converts. I know, I was one of them!

I started trading penny stocks because I really “knew” I couldn’t afford to buy a lot of shares, so it seemed logical that buying a few hundred thousand shares of some stinky pinky was my ticket to wealth and fame. I discovered the golden goose of investing, or so I thought. But after a few years of trading those penny stocks, one thing was very clear. I kept adding funds to my account. It was pretty painfully obvious that my golden goose was nothing but a figment of my imagination. But I digress….

In yesterdays post (http://investorshub.advfn.com/boards/read_msg.aspx?message_id=74268937), I gave an example of buying a call contract of XYZ Company. It was to buy a $30/Call that was to expire next month. The price for this contract was set at $3.50. Our math showed that this contract would really cost us $350.00. For a review, here’s the math:

$3.50 (contract price) X 100 (shares per contract) = $3.50 (out-of-pocket costs)

But there is a bit more to consider before we lay down our hard earned money to buy this contract. We need to consider something called “Intrinsic Value” for the contracts. This can be a little tricky for the new options trader, but nonetheless, we need to get it out there. Before we talk about this we have a few more terms for you to study:

In-the-money (ITM) Contracts – These are contracts where the strike price of the contract has exceeded the actual stock price.

Out-the-money (OTM) Contracts - These are contracts where the strike price of the contract above the actual stock price.

For a better definition see the following chart or go to the following link:
http://www.investopedia.com/terms/i/intrinsicvalue.asp#axzz1rmg6bFxs



Notice the green shaded areas. These are strike prices that are ITM. The rest of the strike prices are OTM. You may also want to notice how TradeKing easily identifies the expiration dates of the contracts listed. So now back to our example of XYZ Company $30/Calls that we want to buy at $3.50. When we buy the $30/Call we want the stock price to move higher than the $30 strike price of the contract. But we’re forgetting a little something.

We need to add that “Intrinsic Value” back into the contract. To do this we simply take the strike price and add the cost of the contract.

$30.00 (Strike Price) + $3.50 (Contract Price) = $33.50

We should do this each time we want to purchase a contract. This is the “real” target price we need to consider. It is our “break even” point. The stock price needs to reach $33.50 for us to just break even. Any stock price above $33.50 is pure profit. Anything below a stock price of $33.50 would be a loss. It really throws a wrinkle into our thinking about a target price and needs to be considered when making a trade.