Expert: Mark Hodge - 7/3/2009

Question
Hi Mark,

Dave here again. I do indeed have a question about Options for you. Not so much for the training, but I'm trying to understand how to conceptually use the information they provide.

Is looking at the price options are going for a good indicator of how the issuers of the stock think it is going to preform?

Essentially, buying a put option on a stock is buying insurance on that stock. If the sale price of the put is, say, 10% of the price of the stock - would that be an indication that it is a less safe investment than one where the put price is only 3%?

Do day traders use this information to determine what to buy and sell, even if they themselves won't be buying the options?

Answer
Hi Dave,

Using the insurance analogy, I could see where you can come to that conclusion, but remember that with insurance you could pay more money to be insured for a longer term (like an option), or to have more coverage (not a PERFECT example, but like in the money options). So it is important to compare apples to apples.

NOTE: I'm going to give examples using calls since most traders find calls easier to relate to, at least at the beginning, but the same ideas would apply to a put.

Example:

Stock XYZ is trading at $20 and we have the following 2 options:
A) 20 strike call that expires in 3 months for $2.00.
B) 20 strike call that expires in 21 days for .60.

In this case we have the same strike price but the 3% option would be considered more "risky" since there are only 21 days to expiration, and the option with more time has a higher probability of making money.

Example 2:

Stock XYZ is trading at $19 and we have the following 2 options:
A) 17.50 strike call that expires in 30 days for $1.75.
B) 20 strike call that expires in 30 days for .50.

The 17.50 strike has REAL value or intrinsic value because the strike price is below the current price and if the stock closed at $19 on expiration, the option would be worth $1.50 ($19.00 stock price - $17.50 strike price)The 20 strike only has TIME value or extrinsic value and would expire worthless if the stock traded below $20 at expiration. Just another example of how the more expensive option was less risky.

Comparing apples to apples...

Let's take stock XYZ trading at $19, and stock ABC trading at $19. Two different companies but the same share price.

IF we have the following options:

A) $20 strike price with 90 days to expiration trading at $1.90.
B) $20 strike price with 90 days to expiration trading at .60.

Now we have the same strike, expiration and stock price so the ONLY difference is the option premium. This is due to volatility. If a stock is expected to move MORE, implied volatility will cause the option to be priced higher. Very quiet stocks will have lower option prices because the stock is expected to move less.

In a nutshell...

All things the same, a higher priced option typically means that there is expected volatility and a stock is likely to move. Looking at a single stock and options, higher priced options are often less risky...you get what you pay for. ;)

To answer your question about day trading, some traders MIGHT scan for stocks that have options with high volatility to find stocks to day trade that might be on the move (but this is often due to earnings, FDA announcements, or events anyway), but I would say that most do not. With day trading you're really focused on what you see, not what you think and many day traders find specific stocks or markets that they feel comfortable trading and stick with them day after day.

I hope this helps!
Mark