# Options Question

I’ve been looking into a few 2 year options lately and had a question. If you look at an option chain for CFC calls expiring Jan 16 2010, you can buy a strike of \$2.50 for \$5.20, a strike of \$5.00 for \$4.30, and a strike of \$7.50 for \$3.70. The current price is \$6.55 In just looking at those 3 options, why would anyone buy anything except the first one? Say the price of CFC moves to \$20 and we neglect commissions for the moment, as it would have the same effect on each option. Let’s assume you buy one contract for 100 shares. The \$2.50 strike costs you \$520. You exercise it and profit \$1,230 ( (\$20*100) - (\$2.50*100) - (\$5.20*100) ). The \$5.00 strike costs you \$430. You exercise it and profit \$1070 ( (\$20*100) - (\$5.00*100) - (\$4.30*100) ). The \$7.50 strike costs you \$370. You exercise it and profit \$880 ( (\$20*100) - (\$7.50*100) - (\$3.70*100) ). Even if you just look at the current prices, it doesn’t make sense to me. If you buy the \$2.50 strike vs the \$5.00 strike, you can buy the stock for \$2.50 less, but the right to do so only costs you .90. Is the only reason that these are out of whack because of the chance of the stock going to 0? So the people who buy the \$7.50 strike know they are getting a “worse” deal than the people who buy the \$2.50 strike, but in the event the option expires out of the money they are only out \$370 vs \$520? Be gentle, this is my first foray into options.

In your payoff scenario, notice that as you accept more downside risk (\$520 loss vs. \$370 loss), you gain upside exposure (\$1230 gain vs. \$880 gain). I realize this is overly simplistic, but without launching into a primer on theoretical options pricing, it’s the best I can do.

You’re correct, most smart and intelligent people would buy CFC 2.50. In addition, the delta on CFC 2.50 (YJD-AQ) is currently at .944, that’s excellent. I work in a brokerage firm and deal with stupid investors all day who trade options and haven’t a clue about them! A lot of people trade options because they are intriguing; however, they don’t educate themselves first. A lot of investors would buy the CFC 7.50, simply because it’s cheaper than the first one. I’ve seen numerous times where at stock is priced at \$50 (we’ll say January 1) and they buy an OTM option at a strike price of 40 for .05, thinking they’re going to make a killing (when it expires in 3 weeks)! Also, about 90%+ of people who buy options (puts/calls) don’t exercise them–they simply trade them. I don’t know about you, but I sure as heck can’t afford to exercise a call option on GOOG! Also, people may have shorted the stock and they are simply buying protection (insurance) just in case CFC flies through the roof…

I agree with alphabound, people don’t want to accept as much risk (buying the CFC 7 instead of the CFC 2.50), meaning, losing 100% of their investment in the option. However, if you buy a deep in-the-money option and the stock price does not move, you will get something back for your investment. If you buy a deep out-of-the-money option and the stock price does not move, you will lose 100% of your investment…

>In just looking at those 3 options, why would anyone buy anything except the first one? Simplest reason is leverage - you can buy more “cheaper” options which means you’ll have the option to buy more shares, which really pays off if the stock takes off… Also think about probabibilities …

Ok, seems to make sense. Looks like I wasn’t all that far off. Thanks for the input.

soxboys21 Wrote: ------------------------------------------------------- However, if you buy a > deep in-the-money option and the stock price does > not move, you will get something back for your > investment. If you buy a deep out-of-the-money > option and the stock price does not move, you will > lose 100% of your investment… This is a terrible way to think about it. Think about it terms of dollars and not %. There’s no safety in deep ITM options. To the original poster, the vol in these options is through the roof. That makes it very tough to be long any of them, puts or calls. Besides, these are 2010s! This stock could go to 40 in that time frame. If think it’s going to make that kind of move, (even if you think it’s going to 20), you want to maximize your gamma. I know I just told someone not to think about it in % terms, but look at your cash on cash returns if you put \$10,000 into jan10 10 calls and the stock goes to \$20.

soxboys21 Wrote: ------------------------------------------------------- > You’re correct, most smart and intelligent people > would buy CFC 2.50. In addition, the delta on CFC > 2.50 (YJD-AQ) is currently at .944, that’s > excellent. > What nonsense. What’s so “excellent” about a 0.9 delta for a deep ITM call option? Deep ITM option always have high delta, so there’s nothing special about the 2.50C. Also, whether you buy a 2.5C, 5C or 7.5C depends on your trading strategies. TO give a very simple case: If I want the upside of a possible CFC revival and limit my loss at the same time, the 7.50C is the right option to buy. Sure, I don’t make as much when CFC hits \$20, but my downside is also protected at 3.7 while a “smart and intelligent” person who buy the 2.5C will be worse-off if CFC goes south of \$4, which is not too far from the current price nor too remote a possibility. Plus buying and selling a long-dated option is almost always about vol speculation, which I will not even try to explain. All in all, very naive understanding of options, its pricing and strategies. Maybe that’s why you work in a brokerage and me, a hedge fund.

HoldSideAnalyst Wrote: ------------------------------------------------------- > soxboys21 Wrote: > -------------------------------------------------- > ----- > However, if you buy a > > deep in-the-money option and the stock price > does > > not move, you will get something back for your > > investment. If you buy a deep out-of-the-money > > option and the stock price does not move, you > will > > lose 100% of your investment… > > This is a terrible way to think about it. Think > about it terms of dollars and not %. There’s no > safety in deep ITM options. > > To the original poster, the vol in these options > is through the roof. That makes it very tough to > be long any of them, puts or calls. Besides, > these are 2010s! This stock could go to 40 in > that time frame. If think it’s going to make that > kind of move, (even if you think it’s going to > 20), you want to maximize your gamma. I know I > just told someone not to think about it in % > terms, but look at your cash on cash returns if > you put \$10,000 into jan10 10 calls and the stock > goes to \$20. Ok, I’ll bite. What exactly do you mean by maximizing gamma? My theory behind this investment, as well as a possible investment in SLM 2 year options, is that both of these companies have been hit hard, and for good reason, in the last few months. A two year option gives them time to recover. I don’t see them going back to where they were before the credit crunch, but I do see them going higher. Using options helps temper the downside risk. If they go to 0, I’m out only the price of the options, not the entire purchase price if I were to go long the stock.

soxboys21 Wrote: ------------------------------------------------------- > Also, about 90%+ of people who buy options > (puts/calls) don’t exercise them–they simply > trade them. I don’t know about you, but I sure as > heck can’t afford to exercise a call option on > GOOG! > > Also, people may have shorted the stock and they > are simply buying protection (insurance) just in > case CFC flies through the roof… Yeah right. I’m pretty sure you made up that “90%” number. You don’t need outlays to exercise a google stock. if you have a call at 200, then you exercise the call at expiry and SIMULTANEOUSLY sell it at market price to lock in the profit. Any self-respecting broker or brokerage can do that for you. Buying a call to protect from short-selling is legitimate, but buying a 3Y call to protect a , supposedly, 3Y short-selling position is quite unheard of. Sorry I have to tear you apart like that. I expect more from someone working in a brokerage.

jrumph Wrote: ------------------------------------------------------- > Ok, I’ll bite. What exactly do you mean by > maximizing gamma? Gamma is the measure of change in the delta of an option as the the underlying price changes. The delta, in turn, is a measure of the change in the options price relative to the underlying. By maximizing gamma, you maximize your profit (in this case). This is probably a little advanced for what you are trying to do.

jrumph Wrote: > Ok, I’ll bite. What exactly do you mean by > maximizing gamma? Let me give you a hint. If you are looking for short-term gain (6-9months) and believe that the current implied vols on the call options is too low (ie the actual vols over the 6-9 month period will be higher than the implied vols today), which option will you buy? 2.5C, 5C or 7.5C?

alphabound Wrote: > Gamma is the measure of change in the delta of an > option as the the underlying price changes. The > delta, in turn, is a measure of the change in the > options price relative to the underlying. By > maximizing gamma, you maximize your profit (in > this case). This is probably a little advanced > for what you are trying to do. Ok, I think I’m ahead of myself here. Seems to me that you are still refering to the basic strategy on maximizing profit (in relative terms, ie return rather than dollar) in the case of a stock revival. I thought you were referring to vols trading since gamma and vega are related. My previous post relates to vega trading.

propanol Wrote: ------------------------------------------------------- > alphabound Wrote: > > Gamma is the measure of change in the delta of > an > > option as the the underlying price changes. > The > > delta, in turn, is a measure of the change in > the > > options price relative to the underlying. By > > maximizing gamma, you maximize your profit (in > > this case). This is probably a little advanced > > for what you are trying to do. > > > Ok, I think I’m ahead of myself here. Seems to me > that you are still refering to the basic strategy > on maximizing profit (in relative terms, ie return > rather than dollar) in the case of a stock > revival. > > I thought you were referring to vols trading since > gamma and vega are related. My previous post > relates to vega trading. There’s so much info in this thread that I am on the verge of understanding, but am just not quite there yet. I’ve got a basic undrestanding of the greeks and what they measure, and of how options work. I’m just weak when it comes to maximizing everything and knowing how the greeks pertain to a specific option. Are there any good, in-depth guides or books out there that will explain all this, or is it really just an experience thing?

If you have decent math background (ie you know calculus), read Neil Chriss’ Black Scholes and Beyond. One of the best I’ve read, especially on Greeks and option strategies. Neil used to work in my previous firm as a quant portfolio manager and now manages his own hedge fund I believe. He was previously the director of Courant’s fin math program but has since moved on to head similar program at UofChicago. it is not possible to get very good at options and their strategies without some level of sophistication in math.

No problem propanol, I am learning as I go. And you’re probably right, that’s why you work at a hedge fund and I don’t. I’m trying to educate myself and hopefully by starting the CFA in the coming weeks, I’ll be where you are in the near future…

soxboys21, My apologies. Was too harsh. Tough day at work.

No worries–I just realized that 99% of the people in this forum are way more experienced and have far more knowledge than I do in any subject discussed on AF. I’ll take this as a lesson and will continue to read posts to gain a deeper understanding…

propanol Wrote: ------------------------------------------------------- > jrumph Wrote: > > Ok, I’ll bite. What exactly do you mean by > > maximizing gamma? > > Let me give you a hint. If you are looking for > short-term gain (6-9months) and believe that the > current implied vols on the call options is too > low (ie the actual vols over the 6-9 month period > will be higher than the implied vols today), which > option will you buy? 2.5C, 5C or 7.5C? dude, I think what your hinting at is a way beyond the scope of the initial question here…

jrumph Wrote: ------------------------------------------------------- > HoldSideAnalyst Wrote: > -------------------------------------------------- > ----- > > soxboys21 Wrote: > > > -------------------------------------------------- > > > ----- > > However, if you buy a > > > deep in-the-money option and the stock price > > does > > > not move, you will get something back for > your > > > investment. If you buy a deep > out-of-the-money > > > option and the stock price does not move, you > > will > > > lose 100% of your investment… > > > > This is a terrible way to think about it. > Think > > about it terms of dollars and not %. There’s > no > > safety in deep ITM options. > > > > To the original poster, the vol in these > options > > is through the roof. That makes it very tough > to > > be long any of them, puts or calls. Besides, > > these are 2010s! This stock could go to 40 in > > that time frame. If think it’s going to make > that > > kind of move, (even if you think it’s going to > > 20), you want to maximize your gamma. I know I > > just told someone not to think about it in % > > terms, but look at your cash on cash returns if > > you put \$10,000 into jan10 10 calls and the > stock > > goes to \$20. > > > Ok, I’ll bite. What exactly do you mean by > maximizing gamma? > > My theory behind this investment, as well as a > possible investment in SLM 2 year options, is that > both of these companies have been hit hard, and > for good reason, in the last few months. A two > year option gives them time to recover. I don’t > see them going back to where they were before the > credit crunch, but I do see them going higher. > Using options helps temper the downside risk. If > they go to 0, I’m out only the price of the > options, not the entire purchase price if I were > to go long the stock. OK, but with a delta of .94, buying the options is essentially the same as buying the stock. The 7.50s or 10s offer a much better upside with the same 0 downside.