Trying to get a quick grasp on options

Business Money
1

I’m an options noob trying to get a grasp on the basics of evaluating various strike prices, if someone can take a quick look at my analysis and let me know if I haven’t messed things up I’d be grateful for the guidance.

(Pretend) I’m looking at buying some April '08 call options for ETFC (E-trade).

Right now, the price of the stock is $4.54.
The price of a call option at a $3 strike is $2.45 (in the money)
The price of a call option at a $4 strike is $1.80 (in the money)
The price of a call option at a $5 strike is $1.45

Going from a $4 strike price to a $3 strike price nets you a gain of $1 per share unless the stock ends up below that strike price, correct? Is that the only reason the price from $4 to 3 only increases by .65 instead of a dollar - that is, the risk associated with the stock dropping below $3 before April?

Let me know if I’m calculating something wrong here:

If the stock price stays exactly the same until the options expire, if I had bought the:

$3 calls — ($4.54-$3-$2.45)x1000 = $910 loss

$4 calls — ($4.54-$4-$1.80)x1000 = $1260 loss

If the stock price tanks to $1:

$3 calls — $2,450 loss

$4 calls — $1,800 loss

If the stock moves to $10:

$3 calls — ($10 - $3 - $2.45)x1000 = $4550

$4 calls — ($10 - $4 - $1.80)x1000 = $4200

(difference will be $350 for any final stock price ~$3)

So buying the $3 call over the $4 call gets me a potential $350 extra gain on the upside, with a $650 potential loss on the downside. To me, the $4 call sounds more reasonable here, since Etrade does have bankruptcy potential.

Out of curiosity, what types of factors go through your head when deciding on which strike price to move on?

Thanks for your help!

2

For me, I look at the following things.

  1. My personal sentiment about the underlying stock
  2. My estimated timeline for that sentiment to play out
  3. My strategy (straight buy, covered positions, spreads)
  4. Volatility <-- important
  5. My risk tolerance for this particular play
3

[quote=“necroflux”]

So buying the $3 call over the $4 call gets me a potential $350 extra gain on the upside, with a $650 potential loss on the downside. To me, the $4 call sounds more reasonable here, since Etrade does have bankruptcy potential.

Out of curiosity, what types of factors go through your head when deciding on which strike price to move on?

Thanks for your help![/quote]

Just a couple comments.

A. Your calculations are basically correct with this caveat: One option represents rights on 100 shares. Your equations multiply by 1,000, suggesting you are considering purchase of 10 options in each instance. Might as well also include transaction costs - depending on your broker it could be meaningful.

B. On your question “What types of factors go through your head when deciding on which strike price to move on?” That’s like asking “What is your favorite color, and why?” Option trading is serious rocket science stuff (unless you are just trading ‘for fun’). Answers you get to this question (here) are almost certainly not worth reading.

C. There are innumerable better places on the web to take your ‘noob’ questions. Some kind soul might PM you a few.

4

Thanks guys. And the kind soul who, miraculously, did indeed PM me a great investment site haha.

5

For trading, especially options, you might take a look at www.tickerforum.org . Lots of tinfoil, but also lots of astute traders.

Options are not rocket science. Options are crack.