So how much cash can we generate selling options on the stocks that have passed our fundamental and technical screens? The answer lies in the option chain. This is a list that quotes option prices for a given security. For each underlying security, the option chain lists the various strike prices, option premiums, expiration dates and whether it is a call or put option. These lists can be found through your online discount brokerage or through various free websites such as:
The first time I looked at an option chain it reminded me of the first examination I took in Organic Chemistry…..I thought I was prepared for it but boy was I wrong! However, like most challenges (except perhaps organic chemistry) these hurdles can be overcome by simply doing your due-diligence and via repetition. For many experienced cover call writers, the knowledge gleaned from the option chain has become second nature and a source of information for our lucrative returns. Knowing how to read an option chain is an essential prerequisite to writing covered calls or any form of options trading. This article is geared to the novice options investor and those new to the BCI community.
Definition of an option chain:
An option chain is a method of quoting option prices through a list of all options for a given underlying security. The option chain reveals the various strike prices, expiration dates and identifies them as calls or puts.
The chart below shows what a typical option chain looks like for June 2010 expiration call options only for Mercadolibre, Inc. (NASDAQ: MELI):
The components of the option chain (columns from left to right):
1- Strike price– Also called the exercise price. For call options, this is the price at which the option holder (buyer) can purchase the underlying security. The strike price usually trades in increments of $2.50 when under $25, in $5 increments when above $25, and in $10 increments for strike prices above $200. Some stocks and exchange-traded funds trade in $1 increments and others in $2.50 increments (above $25) as a result of a stock split. Additional exceptions will be addressed in future articles.
2- Symbol– These are the ticker symbols for options. They identify the underlying equity, the strike price, the expiration date and identify it as a call or put option. The option ticker symbol will always contain the ticker of the underlying security (in the above chart “MELI”).
3- Last– This is the price at which the last trade of that particular option was executed. For example, in the above chart, the last trade for $50 strike was executed @ $1.60.
4- Change– This column indicates how much the price of the option has risen or fallen from yesterday’s closing price. In this options chain, the $50 strike had increased $0.10 from the prior day’s closing price at the time the information in the chart was obtained.
5- Bid– The price at which the market makers are willing to buy your option, or in other words, the price you will receive when you sell an option (sell at the bid, the lower price).
6- Ask– The price at which market makers are willing to sell the option, or in other words, the price you will pay when you buy an option (buy at the ask, the higher price).
7- Volume (Vol) – The number of contracts traded for that option during that trading day. The higher this daily volume, the more “liquid” this option contract becomes vis a vis options with a lower daily volume. However, because each trading day brings a new daily volume, volume is not the most accurate measure of option liquidity. Furthermore, obtaining historical daily volume information for options is much more difficult than obtaining historical daily volume information for stocks.
8- Open interest– The open interest of an option contract is the number of outstanding options of that particular option which currently have not been closed out or exercised. For example, if the open interest for a particular call option is 1,000, this means that there are currently 1,000 active options that have either not been exercised or sold. Because an option is simply a contract, more contracts can be created every day, however the current open interest figure allows investors to gauge the extent of interest that investors have in a particular option contract. It is a cumulative figure, not a daily statistic as with volume. The higher the open interest, the more liquid the option contract is considered.
Example of using option chain to calculate ROO
Now that we are familiar with primary components of an option chain, let’s view an example of how we can use the option chain to calculate ROO or time value, using the option chain in the above chart for our example.
- Assume we buy 100 shares of MELI @ $50. Our cost basis for the purchase of the underlying equity is thus $50/share for a $5,000 total investment.
- Since we now own 100 shares of MELI, we can sell 1 call option (which equals 100 shares) of MELI in order to be “covered” (i.e. we own 100 shares of MELI, and sell someone else the right to buy 100 shares of MELI from us). For this example, assume we sell one $50 strike (one MELI call option with a strike price of $50) for $1.50. Remember, we always sell at the bid, not at the ask unless we negotiate a better price by “playing the bid-ask spread”.
- We are selling an at-the-money option because current price of MELI is equal to the strike price of the option. Accordingly, the $1.50 option premium we receive consists only of time value (it does not have any intrinsic value), and as such, the entire $1.50 option premium is considered profit.
- Our initial 1- month option return (ROO) is 150/5000 = 3% = 36% annualized
The Ellman Calculator
All the mathematics is calculated for you with the Basic Ellman Calculator and the Elite Calculator (free to premium members). Simply access an option chain and enter the stats into the appropriate tab of the calculator.
My new book:
Here is a link that gives some preliminary information:
Mildly good news on economic growth tempered fears of a second recession. Here are some this past week’s mixed economic reports:
- Second quarter GDP increased by 1.3% slightly above the analysts expectations
- The Conference Board’s index of consumer confidence rose only 0.2 points after the August low reading of 45.2
- New home sales hit a 6-month low in August, dropping 2.3%
- Personal income dropped 0.1% in August for the first time since October, 2009
- Consumer prices increased by a modest 0.2%
- Durable -goods orders fell less than expected in August, down 0.1% after a July gain of 4.1%
For the week, the S&P 500 was nearly flat, falling a modest 0.4% for a year-to-date return of (-) 8.7%, including dividends.
Despite a week when S&P 500 was flat, volatility remains a concern. Let’s view a 6-month chart of both:
Note the following:
- Both the S&P 500 (green area) and the VIX (yellow area) have been in a trading range since the market decline in late July
- The green arrow highlights the market decline and the red arrow demonstrates the corresponding spike in volatility
- The S&P 500 has been in a trading range between 1125 and 125 and is currently at the lower end @ 1131
- The VIX has been trading between 30-45 and is at the high end @ 42.96
A concern would be a bearish break out of these ranges on high volume. A bullish bounce is what we are looking for next week. As a result I am downgrading my outlook slightly to neutral but will remain fully invested. Investors new to this strategy may want to take an extremely cautious approach to this market.
IBD: Market in correction
BCI: Neutral, selling in-the-money strikes on all new positions
My best to all,
Alan ([email protected])