[vii] Lesson 1: basic foundation of trading call option

Lesson 1: basic foundation of trading call option

Before buying a call option, it is important to pick the “right” stock to trade option. In this example, Starbucks is chosen as it has qualified the key criteria, namely:
·         Earnings growth (fundamentally strong)
·         Beautiful chart (uptrend and breaking new highs)

Of course we need a few other indicators (Technical Analysis) so that we can time our entry better in anticipation of a bull run (to be discussed in another lesson later).

Chart 1

Chart for SBUX (Starbucks Corp):

As at 8/8/2011, SBUX was trading about $34.04 to $36.52

SBUX has been correcting for a period hence in this example, it is assumed that the indicators signal a strong re-bounce. So, what are the criteria to buy SBUX call option?

Summary of criteria to buy call option:

Expiry month	At least over 60 days and prefer more than 90 days from expiry	e.g. Oct 11 or Jan 12
Open interest	Minimum 300 contracts Some traders prefer over 500	Immediate ITM & OTM
Implied volatility	Prefer below 40% but until 60% acceptable
delta	About 0.50
strike	ITM (OTM can only be accepted if mother share close to next strike)	If share price about $35.90 then pick strike   36

Option chain extract from Thinkorswim platform on the said date:-
Confusing?

Let me explain one by one. First, assume that the mother share is trading at $35.60 at the moment you wish to take position.

 Expiry month

Upon reaching close to the expiry month, the premium on the call option will fall drastically. Take a look at the next chart.

Chart 2

Option chart for SBUX (Starbucks Corp): Aug 11 35 call 

The above chart shows call strike 35 (option is ITM as the mother share is say, trading at $35.60), expiring in August 2011 or another 11 days.

The pink line is the premium price line. Notice how much it has fallen from high of 6.00 to present value of 1.50

The green line is the open interest and surprisingly, not many have exercised their rights to buy the share.

Comparatively, if it is expiring in Oct 11 and at the same strike of 35, the chart looks different. Look at the next chart.

Chart 3

Option chart for SBUX (Starbucks Corp): Oct 11 35 call

 

Oct 2011 (another 74 days till expiry) at the same strike of 35 (still ITM), the premium dropped from $6.50 to $3.00 only. So do you see the difference due to longer expiry period?

 The main difference is the time value. When the option is getting nearer to its expiry, its time value will drop quickly.

Open Interest (O/I)

 Buying a call option is similar to buying shares. Trading volume must be high enough to determine a strong demand. In the case of options, there must be adequate contracts opened so that we have ready buyers when we want to close our option trades. Many traders look at the increase in O/I as an indicator of demand. High demand attracts higher premium.

 It is also an important criterion that a few strikes ITM must also have reasonable O/I numbers.

(Note: search this site for explanation to the abbreviations used herein)

Strike

 Chart 4

Option chart for SBUX (Starbucks Corp): Aug 11 39 call

 

 On the same day of 8/8/2011, SBUX call option strike 39 when SBUX share is trading about $35.60 means this strike price is grossly OTM. As such, the premium is down from high of $2.80 to $0.20 This is because there is only time value left in the option (for the next 11 days). Intrinsic value (difference of strike and trading share price) appears only if the share is trading above $39.00

 We want to buy call option with both intrinsic value (but not too expensive) and enough time value. Hence, we buy just ITM or ATM (i.e. in this example, if mother share trading at $35.60, then we buy call at strike 35 but if it drops below $35.00, then we pick strike at 34)

 OTM can only be accepted if mother share is close to the next strike (e.g. if share price about $35.90 then pick strike 36). Of course all other criteria (technical indicators in the chart) must be qualified too before we take a position.

Chart 5

Option chart for SBUX (Starbucks Corp): Oct 11 39 call

 

In the chart above, call option at strike 39 (OTM) with expiry Oct 2011 (another 74 days more) has its premium dropped from $3.60 to $1.50 (only time value).

Compare this to the premium in chart 3 above, where both are in the same expiry month (Oct) but different strike price. Notice that the premium is $3.00 (if strike 35) compared to the above at $1.50

The difference is the intrinsic value.

Entry

 Therefore, base on the above, when SBUX is trading at $35.60, we buy the following call option:-

Expiry Oct 11

Strike 35

Click ASK

 Do be careful that you click the correct box ASK and not BID.

You want to buy the call option where your loss is limited to the total premium you paid. BID is sell call option and if you have wrongly done that you become the writer (seller) of the option. You will be obligated to sell the share at the strike price if the stock climb at a higher level (the buyer of the call you sold may exercise his right to buy the share from you at the lower price).

 Call option is the right of the holder to buy the share at the strike price specified when market has run higher.

Well, I hope my sharing here can help you in your trading journey.

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