Back-to-basics 5: More options chains
What are options - and why add them to your portfolio mix? In this back-to-basics series, TradeKing’s Brian Overby explains options from the beginning, covering opportunities to risks. This post continues a discussion on options chains, defining open interest, delta and IV.
Welcome back-to-school, traders! So far in this blog series we’ve defined options, both calls and puts, explained what sports and movie contracts have in common with investment options, showed how an option contract’s terms are spelled out in its name, and looked at the basic parts of an options chain. Today we’ll continue the discussion of data you’ll find in options chains. There’s plenty of unpack here, so we’ll just introduce key concepts today and discuss each more later.
As I explained earlier, IBM the stock may have one major “quote”, divided into bid and ask prices, but there may be dozens of options quotes with IBM as the underlying. You can access this list, or “chain” of options quotes at TradeKing at Quotes + Research > Option Chains. (Don’t forget to login first.)
Let’s go back to the IBM option chain I showed you in the last post:
See a larger version of this image.
As you’ll recall, we chose to search for IBM options that are “near-the-money”, in the next expiration month, in this case November 2009. That means all the strike prices immediately above or below IBM’s current per-share price. You can see the strike prices in the gray vertical stripe down the middle. We’ve got calls to the left and puts to the right.
Many of the column headers in this option chain may be familiar: just like stocks quotes, the “Bid” is the price at which you can sell an option, while the “Ask” is the price at which you can buy. “Last” refers to the last trade in each option contract; “Change” and “Volume” are also probably intuitive.
What’s “Open Interest”? Interestingly, unlike shares of stock, there isn’t a fixed number of option contracts out there for a given underlying. Rather the number of contracts is determined by trader demand. That’s why when you place an options trade, it’s not enough to say whether you’re buying or selling; you need to specify if you’re buying or selling “to open” a new options contract, or “to close” an existing one.
“Open Interest” tells you how many options contracts exist right now for a given underlying. This figure is a quick gauge of how much trader interest – literally – there is in a given underlying, as well as a certain option contract. More on open interest in a future post.
How about “delta”? The most well-known of all the option “Greeks”, delta measures how much an option contract’s price will theoretically move for a corresponding one-unit ($1) change in the underlying.
Delta is positive for calls and negative for puts, meaning a $1 upward move in the underlying stock will (theoretically) push a call option’s price up and a put option’s price down. The amount each option would move is specified by delta. (Of course, this assumes that only the underlying price changes, and that all other variables remain the same.)
Delta is an extremely handy concept that deserves a much deeper exploration. Watch for a future post on this and the other “Greeks”.
Now for “IV”, or “implied volatility”. This is another meaty concept for options traders that we’ll explore more fully in a future post. For now, you can think of volatility as coming in two varieties. “Historical” volatility refers to the annualized standard deviation of past stock price movements. In other words, it’s a measure of the daily price fluctuations of a security over the last year.
“Implied volatility”, on the other hand, is what the marketplace is “implying” the volatility of the underlying security to be in the future. The implied volatility number, or IV, is derived from the option’s current price. If no options trade in a security, then naturally there’s no implied volatility for that security.
Implied volatility is the only variable in an options price that’s not directly observable in the markets – but it acts as a critical surrogate for option value.
Last but not least, you may’ve noticed the options ticker symbols in the far-right and far-left columns of options chains. Each ticker represents a specific contract, and they’re built according to a consistent formula of symbols: Underlying + Expiration Date + Strike Price.
Let’s take the IBM Nov 110 call as an example, options ticker IBM.KB. In IBM’s case, its options use the same ticker as the underlying stock: IBM. (That’s not always so, but handy when it is.) The K refers to its expiration date, Nov09. You’ll notice all the November 2009 calls have K in their symbols for this reason. (Similarly, the November 2009 puts all have W in their symbols in this spot.) The B at the end refers to the strike price, in this case 110.
You don’t need to be able to derive an option’s ticker symbol, but if you’re curious as its origins, the symbols for both expiration date and strike price are below. Read on in Investopedia for more.
Next time, we’ll dive into the details of these three key options concepts: open interest, delta, and implied volatility. See you soon!
TradeKing's Options Guy
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
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While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
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