Options: The Basics II

If you're going to employ option strategies as part of your portfolio, you need to know how to find and understand options pricing.

Quotable options
The first time you pull up an options quote can be overwhelming. There's considerable choice when it comes to the strike price and expiry month. Consider the following call option quotes for Apple (NASDAQ: AAPL), which sported a price of $91 at the time of the quotes.

The first thing you'll notice is the plethora of option symbols, all for just one company! But fear not. It's really quite easy to decipher. An option symbol consists of three components:

Option symbol = base symbol + expiration month code + strike price code

The base symbol may be as many as three letters in length, and may be as simple as being the same as the general stock ticker. So, the base symbol for Ford (NYSE: F) is F, the base symbol for General Electric (NYSE: GE) is GE, et cetera. Other companies, particularly those listed on the Nasdaq that may have tickers longer than three letters, are assigned base symbols that may or may not have any relation to the underlying stock's familiar ticker.

The expiration month code tells us, in a single letter, when the option expires and whether it's a call or a put. The letters "A" through "L" are assigned to call option, with "A" denoting a January expiry, "B" denoting February expiry, and so on. Letters "M" through "X" represent put options, "M" assigned to January, "N" to February, and so forth. Expiry takes place the third Friday of the associated expiration month.

The strike price codes are a little more complicated, given that stock prices themselves can be all over the map. At its simplest, "A" refers to a $5 strike, "B" a $10 strike, and so forth.

The highlighted call in the table has the symbol QAAGR, telling us that the base symbol for Apple options is "QAA," expiration month code is "G" and signifies July expiry, and the strike price code of "R" corresponds to a $90 strike price.

You'll also see three prices quoted. The "Last Price" is simply what it says it is -- the last traded price of the option. However, this last price may have been at a very different price than what the next transaction will occur at. Like any security, the "bid" price is what the counterparty is willing to buy the security for, and the "ask" price is what the counterparty is willing to sell the security for. With options, there can be substantially less liquidity in the market. Consequently, you definitely need to watch the bid-ask spread.

Stocks with a greater option volume and greater trading generally have a narrower spread. Those $90 Jul '07 Apple calls have a spread of 1.2% between bid and ask. The stock currently has its bid and ask only one penny apart, meaning the bid-ask spread is a minuscule 0.01%. And Apple has some pretty tight bid-ask spreads. Options on smaller companies can have positively murderous spreads -- 6%, 8%, or even 10% or more.

You'll note that call prices decline, while put prices rise, as the strike price on the option increases. This is as it should be. If IBM (NYSE: IBM) trades at $95, which call option would you anticipate as more valuable? The one letting you buy shares at $90 (which you could immediately turn around and sell in the market for a $5 profit), or the one letting you buy shares at $100 (which would cost you $5 more than what you would pay on the open market today)? Invoking the old "bird-in-the-hand" idiom, you'd happily pay more for the one that comes with the built-in profit. We'll get to option pricing in our next article.

Finally, know that options are sold in contracts for 100 shares. In buying that $90 Jul '07 Apple call, you're buying the right to purchase 100 shares of Apple for $90 before the third Friday in July 2007, and paying $870 ($8.70 * 100) for the privilege. The last column in the table shows the "Open Interest" on that particular option -- the net number of outstanding open contracts. An opening transaction occurs with an initial buy or sell of an option. A closing transaction takes place at a later date to offset the initial buy or sell. An investor who initially buys a put option adds to the open interest. If the investor later sells that put option to close out his position, it subtracts from open interest. Generally, we don't worry too much about open interest, with one exception -- if you're dealing in options where the open interest is only a few hundred contracts, it signifies that low liquidity I mentioned, likely leading to a wide bid-ask spread.

Exercise and assignment
Exercising an option simply means that the buyer of the call or put invokes the right to buy or sell the underlying stock at the strike price. When the option buyer (or holder) decides to exercise, the writer of the option is assigned an obligation to fulfill the terms of the contract. The hypothetical writer of that $90 July Apple call must deliver 100 shares, receiving $9,000 in return.

The mechanics of matching an exercising option holder with an assigned option writer is handled behind the scenes by the options clearing corporation. But once assigned, the writer must fulfill his/her end of the bargain, either delivering shares already owned, buying shares on the open market, or shorting shares and delivering those in fulfillment of the contract (of course, the writer then has the obligation to go back at some point and cover the short).

Know, too, that exercise at expiry is generally automatic and handled by the options clearing corporation, but again recall that most option traders close out their positions with offsetting contracts prior to expiry -- unless expiry happens to be advantageous to the trader.

European or American?
You may occasionally hear the terms "European" or "American" style options thrown around. These terms don't refer to geography, but simply denote differences in the stipulations attached to the options. A European option is one that can onlybe exercised at expiry and not before. An American option is one that can be exercised at any time right up to expiry. Traded options that you'll find quoted are American in nature, although you'll find that early exercise of such an option usually doesn't make a lot of sense (as for why, that topic's coming).  

Reading option quotes is fairly straightforward, but prices often come with wider spreads than do much more heavily traded stocks.

Next up: You know how to get option prices. Now, what do they mean?

Check out more of our options series here.