Option Quotes

The Internet has made the process of reviewing option prices extremely easy. There are dozens of sites that provide quote services. Some of these services provide real- time quotes, but most are delayed by at least 20 minutes. If you want to receive streaming real-time data, you must be willing to pay for it. There are some brokers who will include this as part of their service, so it pays to ask.

Option Symbols

Options symbols are generally a five-digit code issued by the exchange. The first three letters will be the same as the underlying stock symbol with the fourth and fifth digit being used to differentiate option series and types. Many options symbols are reused after an option expires.

Options descriptions are also an important part of an option as brokers will use the description to clarify the options parameters and confirm your order. This will circumvent any mistakes made in repeating the option code and also helps to paint a picture of the options parameters.

Whenever discussing options, the parameters should be outlined in the following order: underlying stock, expiry month (and year), strike price and type (call or put). For example, the ‘XYZ Dec20 50.00 call’ is broken down as follows:

Option Quote Components

When you look up an option’s price, you will usually be presented with a variety of information on each option. Let’s review a few of the most popular quote terms:

• Code (or Symbol): The unique code assigned to the option for trading, clearing and settlement purposes.
• Expiry: The last date the option may be exercised. All unexercised options will expire on this day.
• Bid: The bid is the highest price a prospective buyer is prepared to pay for a specified time for a trading unit of a specified security. If there is a high demand for the underlying security, the prices are bid up to a higher level. Retail traders generally sell at the bid price.
• Ask: The ask (or offer) is the lowest price acceptable to a prospective seller of the same security. A low demand for a stock translates to the market being offered down to the lowest price at which a person is willing to sell. Retail traders generally buy at the ask price.
• Bid-Ask Spread: Together, the bid and ask prices constitute the quote and the difference between the two prices is the bid-ask spread. The bid and ask dynamic is common to all stocks and options.
• Last: The last price at which the option traded. For delayed quotes, this price may not reflect the actual price of the option at the time you view the quote.
• Volume: Option volume is total number of contracts traded that day.
• Open Interest: Open interest is the total number of outstanding contracts currently in the market. It also defines an option’s liquidity; the higher the number, the easier it is to move in and out of a trade.
• Margin Price: Margin price is the calculated theoretical fair-value (also known as model price) of the option. This is often used in preference to the last price as it is updated throughout the day. Often the last price may not have occurred on the day and in some cases for lightly traded option could be weeks old.

Liquidity

Liquidity can be defined as the ease with which a security can be converted to cash in the marketplace. Another way to look at liquidity is in terms of supply and demand. When it comes to options, ATM (at-the-money) options usually have the highest supply and demand (open Interest) because they are less expensive than ITM (in-the-money) options and have a better chance of becoming profitable by expiry than OTM (out- the-money) options. Open interest is the number of open option contracts that exist in the market at any one time.

Another factor is options volume. Volume is the total number of contracts traded that day. A large number of open contracts together with high trading volume provides good liquidity and a healthy market.

• Volume: Option volume is total number of contracts traded that day.
• Open interest: Open interest is the total number of outstanding contracts in the market.

Liquidity gives traders the opportunity to move in and out of a market with ease. As stated, ATM options have excellent liquidity because they have a better chance of being profitable than OTM options. An option that is a long way out-the-money is not going to have a lot of liquidity. Most of the strategies we teach must be applied in specific market conditions to be money makers. Liquidity is one of these market conditions. Liquidity is the ease with which a market can be traded. A plentiful number of buyers and sellers increases the volume of trading producing a liquid market.

Reviewing the open interest and volume of a market is an important step of traders and investors. Liquidity allows traders to get their orders filled easily.

Pricing Process

It is important to understand how the market determines the value of an option. Mathematical formulas exist to calculate the theoretical fair-value or model price of an option based on various components. A change in any of these components will have an effect on an options value. Listed below are the eight major components that affect an options value:

• Whether the option is a put or a call
• Whether the option is an American or European style option
• The risk-free rate of return (interest rates)
• The price of the underlying security (the stock price)
• The exercise (strike) price of the option
• The volatility of the stock’s price
• Any dividends expected from the stock prior to expiry of the option
• The expiry date (the number of days until expiry)

Let’s take a look at each one in more detail:

Put or Call

Puts and calls are simply the flip side of each other. At any time before expiry, puts and calls that are the same amount ITM or OTM will be priced basically the same.

American or European Style

Whether an option is an American style or European style will affect its price. An American style option permits the exercise of the option at any time prior to expiry, while a European style option permits exercise only upon reaching expiry. As the trader has the ability to exercise the American option at any time, it will carry a slightly higher premium because of the additional benefits of the added flexibility.

Risk-free Rate of Return (Interest Rates)

The risk-free interest rate is a factor, but for near-term options (6 months or less) it is a very marginal one. The actions of the interest rate markets will typically have little effect on the price of an individual option. Higher interest rates can increase call option premiums, while lower interest rates can lead to a decrease in call option premiums. The reverse is true for puts. The risk-free rate is factored directly into the price of the option as a discount rate for the expected future value of that option. Thus, if there is not much time left until expiry, a change in the risk-free rate will not affect the option price that much.

Underlying Stock Price and Exercise Price

The major components involved in the pricing of any option are the price of the underlying stock (4) and the exercise (strike) price (5) of the option. The relationship between these two values determines the intrinsic value of the option, as well as how far in-the-money or out-the-money a given option is located. A move in the price of the stock will have a different effect on the option depending on the strike price you choose. An option that is deep in-the-money or out-the-money will behave quite differently to choosing one that is at-the-money.

Volatility of the Underlying Stock

Volatility is a percentage that measures the amount by which the underlying stock is expected to change in a given period of time. Highly volatile stocks have a better chance of making a substantial move than those that are not so volatile. They offer larger up and down swings in price in shorter time spans than less volatile stocks. Large movements are attractive to option traders who are always looking for big directional swings to make their contracts profitable. This is why the options of volatile stocks generally command higher premiums than those that are less volatile.

Dividends of the Underlying Stock

Although each variable is important, dividends are often overlooked. Dividends can play an important role in the pricing of options especially around ex-dividend time. The price of a stock will typically fall once it goes ex-dividend by the amount of the dividend being paid. At the same time, you will notice that option prices underlying the stock will not usually change after such a drop as you may expect. This is due to the fact that the dividend has already been factored into the value of the options.

Expiry Date (the number of days until expiry)

The amount of time remaining until expiry, also referred to as time value, is an extremely important factor. The longer an option has until expiry, the greater the chance it has of becoming profitable, and hence the higher the option premium.