Calling All Traders

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In option trading, a call is a type of contract. Traders can buy calls, which give them the right for a specified amount of time to buy stock at a specified price. The price specified for the stock is the strike price. The time that the contract is in force is described by its expiration date or DTE. The published cost of buying the call contract is the Ask price. The image below is a screen capture of the option chain for Apple (AAPL) made on Sunday afternoon, August 14, 2022, which is when I began composing this post. At the time of the capture the last trade price for AAPL during normal trading hours was $172.10 per share. However, there had been some afterhours trading that sent the bid and ask prices for the stock (not the options) to $171.85 and $171.90 respectively. This information can be retrieved by looking at the area enclosed by a red rectangle. Further below in the image you’ll see a green rectangle that contains information about a call contract with a strike price of $170 and an expiration date of August 19, 2022. The two rightmost columns display the bid and ask prices for this option contract. The ask price is the cost per share associated with this contract. The contract itself bundles 100 shares, so the price of the contract would be $335. Depending on your broker, a fee will be added. TD Ameritrade charges 65 cents per contract, so the total price of the trade would be $335.65. We’re going to do a little thought experiment now and see what might happen if we bought the 170 call, and then we’ll compare those results with what might happen had we simply invested in AAPL stock directly. I’ll use actual data and complete composing this post over the life of the option.

Now take a look at AAPL’s option chain at mid-day Wednesday, August 17,2022, which is when I wrote the following section of this post.

Mid-day on Wednesday AAPL’s bid price (what it can be sold for is now $173.38. We also see that its high so far on Wednesday is $174.45. The bid price for the 170 strike has risen to $3.80.

Let’s consider a couple scenarios for our imaginary trade. If we closed the trade by selling the $170 option for $3.80, we’d realize a profit of $0.45 per share. Since the contract was for 100 shares, our total profit would be $45 minus fees of $1.30 (65 cents for each of our two transactions). Net profit would be $43.70).

Let’s analyze our resulting profit a bit more. The total risk we assumed before applying fees was $335. If we divide our gain before applying fees by this amount we have: 45 / 335 = .1343 or 13.43%. We earned this gain over three days. Anualized, the gain would approximate 1634%, a stunning return.

Now, let’s examine a second scenario. Say we simply bought a hundred shares of AAPL for $171.90 per share, when that was its price. We would be investing (i.e. risking) $17,190. If we sold that stock on Wednesday at $174.45 per share, we would be paid 17,445 for that sale, a profit of $190.00. How can we measure the percentage return on risk in a stock purchase like this one? By convention, we’d divide our return (190) by our purchase price ($17,190) and be happy with 1.1% return over the three-day period. Realistically, we know, though, that our risk was really much less than $17,190 because the likelihood that AAPL shares would fall to zero is infinitismally small. We can, however, estimate our risk by looking at how AAPL share prices vary in the past. There are many statistical ways to make this estimate, and as new traders become old traders, they develop preferences for how they make such estimates.

An important take-away: Options can be a very efficient use of capital.

Now, it’s Thursday. About 24 hours has passed since my last update to this post. It’s 11:34 ET. Last price for AAPL is $174.66. The 170 strike can be sold for $4.70. You know how to do the math to calculate our profit/loss depending on whether we exercise the option or close it. Tomorrow is the expiration date for our option. So far, we haven’t considered what will happen at expiration. That depends entirely on what AAPL is trading at when trades are settled after the market closes. If the the closing price of AAPL is less than $170, the option will expire worthless. You will have lost your opportunity to close the trade at a profit. If AAPL trades above 170, it will automatically be excercised unless you tell your broker ahead of time that you don’t want it exercised. When the option is automatically excercised, you have just bought 100 shares of AAPL for $170 a share. If you don’t have $17,000 available in your account, you’ll have to free up that amount either by liquidating other holdings or depositing more money. You can also sell your stock after the market reopens on Monday for whatever the trading price is then. You might win some money or you might lose some money. The vast majority of traders will close their option trades before expiration to avoid the uncertainties associated with expiration. We will explore these uncertainties in greater detail in later posts.

So what should be done today? Nothing? Exercise? Close the trade with a $90 profit? I’m not going to recommend a path, but I’ll tell you what I would do and why I would do it. I’d close the trade and be satisfied with the profit. I would not excersize the option because I don’t want to tie up $17,000 in AAPL stock. I would be happy to have $90 by closing the trade and eliminating the worry going into tomorrow.

Today is Friday, August 19, 2022. When the market closes this afternoon, those holding this trade will have no more control over it. The value of our option contract will go to zero. If AAPL remains above $170, we will become the owners of 100 shares of the stock. Our total cost for those shares will be 17,000 plus the $335 we paid for the option contract plus the 65 cent fee we paid to open the contract: $17,335.65. Last night AAPL closed at $173.75. At 10:56 ET this morning it’s trading at $171.86. We could buy back our option contract for $355, a loss of $20 for the trade. To break even on excercising the option (without considering the 65 cent fee for opening the contract), AAPL would have to trade at 173.35 (170 + 3.35).

Not to be smug, I would have closed the option yesterday, and walked away with 90 dollars. We should think seriously about getting out of the trade before it expires, else we cast our fate to the wind. I’ll report AAPL’s close after market tonight.

August 19, 2022, after market close. AAPL closed out the week at $171.55. Had we kept our trade open through expiration, we would expect our option to be automatically exercised for $170 a share (17,000). We could sell those one hundred shares after the market reopens next week. We don’t know for sure what the price of AAPL will be then. If it stays put, we will have lost $180.65:

Cost of 170 call option	$335.00
Transaction fee	$000.65
Value of 100 shares at expiration	$17155.00
Net	-$180.65

Finallly, let’s look at the chart that records the option’s price swings.

The chart was captured at closing, so the rightmost candle’s closing price is composed only of intrinsic value; that is, the difference between the strike price and the price of the underlying stock. In a future post we’ll examine in greater detail both intrinsic value and this chart.