How exactly do options for equity shares work?

Question

How do you calculate the spread of these options?

Are you only in the money when you surpass your strike price, or can the option in and of itself appreciate in value, independent of the strike price (in the very short term, for example)?

As you buy an option closer to your strike price (that is, closer to being in the money), does the spread increase? and how can you tell?

As you get much farther away, does it get much cheaper?

What is the best bargain (the balance between the closest and the farthest to the strike)?

Thanks!

Answer 1

You can answer most of these questions here, at the Yahoo options section:

http://biz.yahoo.com/opt/

Here is the option page for IBM

http://finance.yahoo.com/q/op?s=ibm

You already seem to know the terminology, so look at the prices of the different strikes and months for answers.

The "best bargain" seems to be the cheapest one, but is the greatest risk, since IBM won't go to 200 by next Friday, or the Friday after that, which is Options Expiration. So the July 200 Call will expire worthless, and is not a bargain, no matter how cheap. It helps to have a target or projection, and that helps determine your strike more than anything.

IBM could certainly go back to it's highs at 130, so the 125 call option is a good choice here for purchase and "balance," assuming you believe the market will rally out of these lows. For your spread, you could sell the 130. And yes, the spread will widen as it goes deeper in the money, and as expiration approaches. To be safe, you should never purchase options with less than 3 weeks remaining, so the Aug Call would be the correct choice for this example.

Or you could get fancy and create a Delta Neutral spread by buy 100 shares of IBM and then either buying two ATM (at-the-money) Puts, or sell two ATM Calls. The unlimited risk of selling options is not recommended. Or you can short the stock, and do the opposite with the options.

Answer 2

<<<How exactly do options for equity shares work?>>>

An adequate answer to that question would take more space than is available in this forum. I agree with the advice that Michael L gave you to go to the CBOE site learning center to get the basics. The URL is

http://www.cboe.com/LearnCenter/default....

I also recommend the OIC eduation site

http://www.optionseducation.org/

<<<How do you calculate the spread of these options?>>>

There are mulitple types of spreads and I am not sure which one you mean. When talking about a single option "the spread" would usually mean the bid-ask spread, which is calculated by subtracting the bid price from the ask price. If you are talking about the spread between two options, you subtract the price of the lower priced option from the price of the higher priced option.

<<<Are you only in the money when you surpass your strike price>>>

In the option world, "in the money" means an option that has intrinsic value. It does not have anything to do with whether a position you have has an unrealized profit or loss.

<<<can the option in and of itself appreciate in value, independent of the strike price (in the very short term, for example)?>>>

The option can appreciate in value independent of the strike price due to

(1) a change in price of the underlying

(2) an increase in implied volatility, or

(3) a change in the "risk free" interest rate.

<<<As you buy an option closer to your strike price (that is, closer to being in the money), does the spread increase?>>>

Once again I am not sure what you mean by spread, so I am not sure if I am answering your question.

The spread between two call options with strike prices a fixed number of dollars apart decreases as the strike prices increase. For example, the spread between a $40 call and a $50 call with the same expiry and underlying will be more than the spread between a $60 call and a $70 call with the same expiry and underlying.

The spread between two put options with strike prices a fixed number of dollars apart increases as the strike prices increase. For example, the spread between a $40 put and a $50 put with the same expiry and underlying will be less than the spread between a $60 put and a $70 put with the same expiry and underlying.

<<<and how can you tell?>>>

I know that is true because I understand option pricing, but even without that knowledge you could see the difference by looking at an option quote montage.

<<<As you get much farther away, does it get much cheaper?>>>

See the previous two answers in this post.

<<<What is the best bargain (the balance between the closest and the farthest to the strike)?>>>

It depends upon your prediction of future volatility. If you think current implied volatility is too high, you should buy the option that is closer to being at the money in your spread. If you think current implied volatility is too low, you should sell the option that is closer to being at the money in your spread.

If you don't think implied volatility is either too high to too low, you should not trade options on the underlying.

Answer 3

There are a lot of variables that go into option investing and option pricing.  There is the intrinsic value, premium, time value.  

I suggest before you get in too deep and before accepting any advice from this forum you educate yourself as best you can.

The Chicago Board of Exchange is a great place to start.

www.cboe.com/LearnCenter/Concepts/Basi...

Options and options strategies can be complex but rewarding to those who put in the time to study.

I suggest you start "paper trading" first.  Be honest about it.  Give yourself a make believe amount of money and start a portfolio.  If you do some looking you'll find websites that allow you to paper trade before opening an account with them.