Bid and Ask Prices

Let’s take a brief detour here to learn more about what the bid and

ask represent since they can be confusing to new traders. Notice that

the $32.50 call shows a

bid price of $4.70 and an ask price of $4.90.

You have to remember that the options market, just like the stock

market, is a live auction. There are traders continuously placing bids to buy and

offers to sell. The bid price is the highest price that someone is willing to pay at

that moment. The asking price is the lowest price at which someone will sell at that

moment. If these terms are confusing, think of the terms you use when buying or

selling a home. If you wish to buy a home, you submit a bid. Buyers place bids.

If you were selling your home, you’d say I am “asking” such-and such a price for

it. Sellers create asking prices. Sometimes you will hear the word “offer” instead of

“ask” but they mean the same thing. If the bid represents the highest price someone

is willing to pay that means you can receive that price if you are selling your option.

You are selling to a buyer and the trade can get executed. Notice that you cannot

sell at the $4.90 asking price because that is a seller too and you cannot execute a

trade by matching a seller with a seller.

Likewise, if you are buying this option, you should refer to the asking price to

see how much it will cost you. Since the asking price shows the lowest price that

someone will sell, we know you can buy the option for that price. In this case,

you are buying from a seller and the trade can get executed. This is important to

remember since the price you pay or receive depends on the bid and ask. This trade

may appear to be a good deal if you can sell for $4.90 but you will be disappointed

if you find that you only receive $4.70. You need to be aware of which price applies

to your intended action.

In summary, if you are selling then you should reference the

bid price. If you are buying, you should look at the asking price.

This is especially

critical for options traders since the volume on options is not as high as it is for the

stock and, consequently, options will have larger spreads between the bid and ask.

For example, in the upper right corner of Table 1-1, you can see that the stock is

bidding $37.10 and asking $37.11, which represents a one-cent spread between

the buyers and sellers. However, the $32.50 call option is bidding $4.70 and asking

$4.90, which is a 20-cent spread. The bigger that spread, the more critical it is to

understand what these numbers mean, otherwise you could be in for an unpleasant

surprise when trading. We’ll learn more about the bid and ask in Chapter Four

when we examine the Limit Order Display Rule and how you can use it to your

advantage to lessen the effect of the spread.

The “bid” price represents the highest price that a BUYER is willing to

pay. It is consequently the price at which you can sell the option.

The “ask” price represents the lowest price that a SELLER is willing to

receive. It is consequently the price at which you can buy the option

Okay, let’s try the next call on the list in Table 1-1, which is the

05 Jul 35 call

(notice that the strikes are in $2.50 increments since eBay is below $50, which is

in agreement with what we stated earlier). If you buy this call option, you have the

right, not the obligation, to buy 100 shares of eBay for $35 per share through the

third Friday in July ‘05. Since eBay is trading for $37.11, we know that anybody

holding this option has an immediate advantage of $37.11 - $35 = $2.11 by buying

this call and we now know that this advantage must be reflected in the price. You

can verify that the asking price is $2.70, which shows the apparently free $2.11

benefit is not free. Again, the reason traders will pay more than the $2.11 benefit

is because there is time remaining on the option and it certainly could end up with

more value. If you want to buy this contract, it will cost you $2.70 * 100 shares =

$270 per contract + commissions. If you buy two contracts, you will control 200

shares and that will cost $540 and so on.

While we’re talking about the prices in Table 1-1, let’s explain what the rest of

the columns mean. The

LAST SALE column records the price of the last trade of

the option. Option traders rarely look at this, since that price could have occurred

during the last minute but it also could have been last week. We don’t know when

that trade took place. We just know that was the price when it last traded. For stock

traders, the last sale will generally be very close to the bid and ask of the stock,

because optionable stocks generally have high volume – but that is not necessarily

true for their options. In Table 1-1, you can see that the last trade on eBay was

$37.11 with the bid at $37.10 and the asking price at $37.11. The last sale for

the stock is very close to the current bid and ask, which will usually be the case.

But notice that the last trade for the $32.50 call was $4.40 with the bid and ask at

$4.70 to $4.90. This shows that the last trade is somewhat stale; that’s why option

traders generally do not look at the last trade. If you were buying this option, the

last sale would lead you to believe that it would cost $4.40 when it would really

cost $4.90. If you were selling the option, the last sale may make you decide against

it since it appears you would only receive $4.40 when, in actuality, you get $4.70.

The

NET column shows the difference, or the “net change,” between the last

trade and the last closing price just as it does for stocks. For the July $32.50 call, the

last trade was $4.40 and that price was down $1.20 from its previous price, which

means the previous trade was $4.40 + $1.20 = $5.60. If this option traded at $5.60

and the next trade was at $4.40 then that represents a $1.20 drop in price, which is

what the

NET column shows. Again, the reason for the apparent big drop in price

is because there was a big time delay between those two trades.

The

VOL column shows us the volume, which is simply the number of

contracts traded that day. For the stock market, volume refers to the number of

shares traded; for the options market, it refers to the number of contracts but the

idea is the same.

The

OPEN INT column shows how many contracts are currently in existence,

which is called the “open interest.” We’ll find out more about open interest in

Chapter Four.

A brief explanation, however, is worth mentioning here. When you buy or sell

a contract, you must specify whether you are entering or exiting the contract. If

you are entering into the contract (or increasing the size of an existing position)

then you are “opening” the contract. However, if you are exiting the contract (or

decreasing the size of an existing position) then you are “closing” the contract.

Most brokerage firms require that you specify whether you are opening or

closing the position. For instance, if you wish to buy 10 Microsoft July $30 calls

you would enter the order as “buy to open” 10 Microsoft July $30 calls. You would

not say “buy” 10 Microsoft July $30 calls. The reason is that the word “buy” alone

doesn’t tell the broker if you are buying the calls to own them (opening transaction)

or if you are buying the calls to close a short position (closing transaction). Using

the words “to open” or “to close” clarifies your intentions.

Some of the newer firms do not require the use of the words “opening” or

“closing.” Instead, they account for it based on the existing positions in your

account. For instance, if you have no Microsoft July $30 calls then the above order

is recognized as an opening transaction. On the other hand, if you were short 10

Microsoft July $30 calls then the order is recognized as a closing transaction.

Every time the buyer and seller are entering an “opening” order it adds to the

open interest. For instance, if you are buying 10 contracts to open and the seller is

selling 10 contracts to open, then open interest is increased by 10.

If the buyer and seller were, instead, both entering “closing” transactions, then

open interest would decrease by 10 contracts. Finally, if one is “opening” while the

other is “closing,” then that order has no effect on the open interest.

Open interest provides a measure of how many contracts are currently in

existence and therefore provides a measure of liquidity. That’s what the open

interest column shows.

Understanding a Real Call Option

Now that you know how call and put options work, let’s take a look at some

real call and put options. Let’s pull up some quotes and see if we can make some

sense of what we’re looking at.

You can obtain option quotes for any optionable stock by going to www.cboe.

com. That’s the homepage for the Chicago Board Options Exchange (CBOE),

which is one of the largest option exchanges in the world. Bear in mind that the

options market is open from 9:30am to 4:02pm ET (it is open until 4:15pm ET for

index options). If you are pulling up quotes after 4:02pm, you’re looking at closing

prices rather than live quotes. Also, options go through what is called an

opening

rotation

every morning. This is simply an open outcry system that establishes option

prices based on the current stock price openings. For this reason, you may not see

live option quotes until 9:35 or 9:40 even though the options market is technically

open at 9:30.

If you click on “Quotes” and then “Delayed Quotes” you will find a box where

you can type your stock ticker symbol. If you are looking for options on eBay,

for example, just type the ticker symbol “EBAY” and hit enter. At this time, the

shortest-term options on eBay were July ’05 (26 days until expiration) and the

longest term was January ’08 (943 days to expiration). The lowest strike is $22.50

and the highest is $80. So even though option contracts are standardized, there are

many to choose from. Table 1-1 shows some of the shorter-term options available

at the time of this writing:

Before we continue, we need to introduce some more terminology that has

been deliberately withheld until now for the fact that it will be easier to understand

at this point. There are three main classifications for options. First, there are two

types

of options: calls and puts. Second, all options of the same type and same

underlying represent a

class of options. Therefore, all eBay calls or all eBay puts

(regardless of expiration) make up a class. Third, all options of the same class, strike

price, and expiration date make up a

series. For instance, all July $32.50 calls form

a series

At the time these quotes were taken, eBay stock was trading for $37.11, which

you can see in the upper right corner of Table 1-1. The first column is labeled

“calls” and several columns to the right you will find one labeled “puts.” The first

call option on the list is

05 Jul 32.50. The “05 Jul” tells us that the contract expires

in July ‘05 and the “32.50” designates that it is a $32.50 strike price. The last

trading day for this option will be the third Friday in July ‘05. All you have to do

is look at a calendar and count the third Friday for July ‘05 and that is the last day

you can trade the option (which happens to be July 15 for this particular year).

Remember, you can buy, sell, or exercise this option on

any day, but the last day to

do so is July 15. All 05 July options will expire on the same date regardless of the

strike price or whether they are calls or puts.

The “

XBAGZ-E” notation is the symbol for that option. Just as every stock

has a unique trading symbol, each option carries a unique symbol. However, you

can forget about the “dash E,” as the letter E is a unique identifier for the CBOE,

which just tells us these quotes are coming from that exchange. If you wanted to

buy or sell this option online, you’d enter the symbol “XBAGZ.” Your broker,

however, may require you to follow this symbol with “.O” to show that it is an

option (for example, XBAGZ.O). Your broker will make it very clear if he has these

requirements, but the actual symbol (XBAGZ in this example) will always remain

the same regardless of which brokerage firm you use.

Your brokerage firm may list option symbols as “OPRA” codes. The committee

named for consolidating all of the option quotes and reporting them to the

various services is called the Options Price Reporting Authority or “OPRA.”

An OPRA code is the same thing as the option symbol. You can read more

about OPRA at www.OpraData.com.

The $32.50 strike means that the owner of this “coupon” has the right, not

the obligation, to buy 100 shares of eBay for $32.50 through the third Friday of

Jul ‘05. No matter how high a price eBay may be trading, the owner of this call

option is locked into a $32.50 purchase price. Now this seems like a pretty good

deal since the stock is trading much higher at $37.11. It appears that if you got the

$32.50 call, you could make an immediate profit of $37.11 - $32.50 = $4.31. In

other words, it appears that if we could get our hands on this coupon, we could

buy the stock for $32.50 and immediately sell it for the going price of $37.11

thus making an immediate profit of $4.31. However, you must remember that call

options, unlike pizza coupons, are not free. It will cost us some money to get our

hands on it.

How much will it cost to buy this coupon? We can find out by looking at the

“ask” column, which shows how much you will have to pay to buy the option. It

shows a price of $4.90 to buy this call. This means the apparently free $4.31 is no

longer free since you’re paying $4.90 for $4.31 worth of immediate benefit. In fact,

you will find that you must always pay for any immediate advantage that any call

or put option gives you. The main point is that you cannot use options to collect

“free money” in the market. When traders are first introduced to options, they

often think they can buy a call option that gives them an advantageous price and

then immediately exercise the call for a free profit. They overlook the fact that the

price of the option will more than reflect that benefit. Why would someone pay

$4.90 for $4.31 worth of immediate benefit? Because there is time remaining on

the option. It is certainly possible that the option will, at some point in time, have

more than $4.31 worth of benefit, and traders are willing to pay for that time.

The $4.90 price is also called the

premium. The premium really represents the

price per share. Since each contract controls 100 shares of stock, the total cost of

this option will be $4.90 * 100 = $490 plus commission to buy one contract. So if

you spend $490, you can control 100 shares of eBay through the expiration date

of the contract. That’s certainly a lot less than the $3,711 it would cost to buy 100

shares of stock. If you buy two contracts, you will control 200 shares and that will

cost $980 plus commissions, etc. Remember, we said that all options control 100

shares when they are first listed but it is possible for them to control more shares,

which is usually due to a stock split. If that happens, it is possible for the contract

size to change, which we will expand on more in Chapter Four. The main point

to understand is that you always multiply the option premium by the number of

shares that the contract controls in order to find the total price of the option. In

most cases, you will multiply by 100