Option Basics #5: Option Chains II

In our last column, we began to explore the wealth of information hiding in the Option Chain. We defined the columns and we went through the information to be had from the “symbol,” “last,” “change,” and began the “bid” and “ask.” Now, let's move ahead. I duplicated the option chain we used in our last column for the sake of consistency.

Bid & Ask
Remember, if someone is looking to purchase the IBM April $80 call option, to find the posted price for that option they would look at the “ask” price – in our example: $5.20. If you already owned the $80 call option and wanted to sell it, you'd look at the “bid” price ($5.10) to see what you can get.

Notice that there is a $.10 difference between the bid and the ask prices. That is known as the “bid/ask spread.” Where does that money go? Into the pocket of the market makers. That's how they get paid for making a market in that option. The amount they will ask for may vary from stock to stock and from option to option, but they will be there. Bid/ask spreads on some stocks can be as low as $.05 and as high $1.60 on others.

Being Represented
Now, look at the chain again – check out the IBM $75 April call. You'll see that the bid price is $9.70 and the ask price is $9.90. The bid/ask spread in this instance is $.20. Remember the definitions of the “bid” and “ask” prices. The “bid” is the most that someone (including the market maker) may be bidding to BUY the option. The “ask” is the most that someone (including the market maker) is ASKING FOR as they try to sell that option.

Just because in the IBM $75 call the current “ask” is $9.90, it doesn't mean you HAVE TO pay $9.90. You can offer less and see what happens. You can offer $9.80 for that option. The $.10 may not seem like a lot. However, if you're trading 10 contracts (equivalent of 1,000 shares), that $.10 represents $100. Is it worth it? Maybe. Maybe not.

When you offer the $9.80, the market maker now has a choice – he can compromise by $.10 and fill your order. The other choice is that he DOESN'T fill your order. He can simply “represent” your order to the market. He would do this by changing the bid/ask price to $9.70 (bid) by $9.80 (ask).

By trying to negotiate with the market maker, you are taking a chance. What if, while you're waiting to possibly get filled, IBM starts to move up? As IBM moves up, the $75 call option will get more expensive. So, if you were bidding $9.80 for the option before, the ask price might now have increased to $10.10 – without your order being filled. You would have missed purchasing the option in the hope of saving $.10. It's a calculated risk. Option buyers (speculators) are taking a shot in the dark to begin with. Taking that extra risk for $.10 is consistent with the gambling mentality, but not necessarily the wisest thing to do. But “wise” and “traders” don't often appear in the same sentence.

Another example: Look at the option chain again. This time, let's look at the put (right) side of the chain. Notice the IBM April $90 puts are bidding $5.30 and asking $5.60. Assume for a moment that you previously purchased the $90 put and now you want to sell it. Currently, the market maker has posted $5.30 as the price he would pay you for that option. However, you might want to receive $5.40 for the option, so you place your order for $5.40. Again, the market maker has two choices – FILL your order or REPRESENT your order to the market.

If he doesn't fill your order, he will have to show a new bid and ask price. It would change to $5.30 bid price and $5.40 ask price. You assume the same risk that we discussed in the previous example. IBM could move up. As IBM moves up, the value of the put option will go down and you may miss the chance to sell your $90 put option at a good price. IBM may come back down later or tomorrow, but, then again, it might not.

Just keep in mind that the market is constantly changing – especially stocks that are liquid and are regularly in the news. Will IBM move up or will it move down when you're ready to buy or sell? You have a 50% chance of being right. You might as well be flipping coins. Want to take that chance? Regardless of how foolish that sounds, there is a bottomless pit of people who think they can outsmart the market. They think they can look at a chart and determine where a stock may go. As the saying goes, a trader and his money are soon parted – except the original word “fool” has been replaced by “trader.”

You may or may not choose to use certain strategies. However, it's important that you know and understand the concepts so you can make educated decisions. You probably worked hard for your money. I'm just trying to help you keep as much as possible and possibly make some more along the way.

Volume
This one is easy and can be useful. “Volume” represents the number of option contracts that have been traded on that particular trading day. We don't know, at that time, if the options were purchases or sales. All we know is that the options were traded.

Look at the IBM $85 call. According to our option chain, 1,074 contracts were traded that day. Maybe 750 of them were purchases and 324 were sales – we just DON”T KNOW! It could be any combination. All we know is that there is interest in the $85 call. It's no big surprise because the option strikes closest to where the stock (IBM) is trading are usually the most active.

Open Interest
This is an interesting number. “Open Interest” represents the total number of open contracts that are in existence since the option was opened for trading. An open contract means a position that has been initiated and not closed. When you purchase 10 contracts of the IBM $85 call, that translates into 10 “open” contracts – and those 10 contracts will be added to the Open Interest number. When you sell those 10 contracts, whether for a profit or a loss, that will be become a “closed” and deducted from the Open Interest number.

Open interest numbers are calculated and available for the opening of the next trading day. If you open a new position by buying 10 contracts on a Thursday, these 10 contracts will appear in the “Volume” column, but they will not be represented in the Open Interest number until Friday.

(If you have any questions, feel free to email Mike at: mikeparnos@comcast.net)