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How do options work exactly?

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Rob_ee

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I have a basic understanding what options are but am unsure how they work exactly.


As an example a stock is currently trading at 50c and options are available for purchase for 20c exerciseable in 2008.
So if I was to purchase the 20c options could I convert them to shares right away OR do I have to wait till 2008 before this is done?

And if I can exercise them immediately how much extra above the 20c purchase price would I have to pay to convert them?
Obviously there must be advantages in buying options otherwise people would not do it... what would that be exactly?

Explanation would be appreciated in such a way that a newbie can understand please.

Rob
 
This sounds like company options rather than the ETOs (exchange traded options) and I am more familiar with ETOs.

That said, there would be a similar time value component whether they be company or exchange traded. That means if you buy now, you would be paying a premium over and above intrinsic value to purchase the option and this will gradually erode with time from now until the exercise date in 2008.

CALCULATING INTRINSIC VALUE (calls): (current stock price) - (strike price) = (intrinsic value).

EXTRINSIC VALUE (often referred to as "time value"): Any amount greater than intrinsic value and is made up of various components such as time value, volatility, interest rates, etc. This is the cost of holding the option to expiry.

If you exercise your option immediately after purchase, you effectively give away the money you have just invested for the extrinsic component of your option. Better to simply buy the shares if you are planning to own them anyway.

So, the only time you would usually want to exercise an option you own is if there is no extrinsic value left in it and this is usually at or close to expiry.

If you purchase the option and then decide you want out, you can always sell it again on the market to redeem any extrinsic value that may be left in it. At least, that is the case with ETOs, so suggest you check any relevant conditions should it be a company option.

Hope this helps, otherwise there may be someone else that can help with the company option side of things and if there are any other costs involved in exercising a company option.
 
Specifically I am interested in VRE ... have 20000 shares at moment

VREO are buy .215 sell .23

So if I bought VREO for 23c on Monday .. how exactly would that be different from VRE shares which are currently trading @ .39 and would that be a good/bad ? buy based on latest share price difference

I am still learning the ropes.

Rob
 

OK Rob - have looked it up and VREO has an strike price of 20c
VRE closing price on Friday = 39.5
This means VREO currently has intrinsic (real) value of 19.5c
So, if you purchased the option for 23c at close on Friday with VRE @ 39.5c, you would be paying extrinsic (time value) of 3.5c
If you exercised immediately (and I'm not sure if you can exercise these prior to expiry anyway, so check their documentation), you would effectively give away that 3.5c
(Have used Friday's close as we don't know where VRE will open on Monday and it could affect the option price.)

Another way to look at it is that you are paying the strike price of 20c + 23c for the option = total of 43c. You can buy the shares outright for 39.5c - so once again, you are 3.5c worse off if buying the option vs. the shares.

It's good or bad depending on what you want - there are trade-offs.

If you want a leveraged shorter term trade using the option and then plan to sell it while it still has some extrinsic value in it, then the option could be considered. Part of the 3.5c extrinsic value also gives an inbuilt protection at 20c until expiry. You could buy and hold them until expiry when the time value would be gone, so then need to weigh up whether it's better to just buy the shares outright.

As I mentioned in the last post, the 3.5c extrinsic value will gradually erode until 30th June, 2008 when it expires. You will also find that extrinsic value fluctuates depending on the price of the underlying share and the time to expiry.

The ASX website has some free online courses for options as well plenty of other interesting info on options in general. While is is mainly applicable to ETOs, it would give you a basic understanding of how options work.

Please remember, I don't trade company options, so I am no expert on them and do suggest you read any relevant documentation so that you understand exactly how these things work - and look for any specific conditions imposed on these options by the company VRE.

Don't be discouraged - it's not easy learning options!
 
Hi guys,

I've got a related, but slightly different question which I was hoping someone could kindly answer. (I checked the other options thread but couldn't see a straight-forward answer).

I've recently bought into an IPO for MAV. Say I bought 10,000 shares, which included 5,000 MAVO options "exercisable at $0.20 at any time up to 30 June 2010".

The SP for MAV is currently at $0.34...so am I right in assuming that, if I wanted to, I could do the following right now?
- Exercise the MAVO options, at a cost of $1,000+brokerage fees.
- End up with $1,700 worth of MAV @ $0.34?
- Sell that $1,700 worth of MAV @ $0.34, for a profit of $700?

Alternatively, I could simply sell my MAVO for whatever the current price is?

Just want to make sure i understand the whole "exercising options" process, as opposed to actually buying and selling options.

Also, I'm assuming once exercised, I own regular MAV which I can treat as I would a normal share (ie: instead of selling now, I can keep for however long).

Thanks all. Probably a pretty basic questions, but I'm quite new to this.

Cheers,
- Febs.
 
Correct.

But you need to do some sums.

If the options have any extrinsic value, you are better off just selling the options to capture that extrinsic, otherwise you forfeit it and it is a loss.

Extrinsic value = time value

For example, if the shares are 34c and the options are 17c, there is 3c of extrinsic value which you will lose by exercising.
 
wayneL said:
For example, if the shares are 34c and the options are 17c, there is 3c of extrinsic value which you will lose by exercising.
Click to expand...

So basically, I would have to work out the SP relative to the current option price (ie: the price at which I could sell MAVO), to see if it was worth it?

Taking today's close prices:
MAV $0.34
MAVO $0.14

So, forgetting brokerage fees, there would be no difference in either selling 5,000 MAVO @ $0.14, or exercising them, then selling @ $0.34. Either way I would be $700 ahead...

...but if the SP was higher (and option price still $0.14) I would be better off exercising then selling MAV?

Is that right?

Thanks for the quick reply.

Cheers,
- Febs.
 

By exercising you would be incurring 2 sets of brokerage so there is no benefit in doing that, just sell the options.

Now because you have zero extrinsic value, the delta of the option =1. That means the sahre and the option will move lockstep with each other. So the share price goes to 40c, the option will move to 20c.

Either way there is no benefit in exercising the option, just sell it when you want to wind up the trade.

Even if you want to hold long term, you are better off holding the option til expiry and exercising then, because you are limiting your risk. Under the set of conditions as they are, there is no advantage in the shares at all.
 
Great explaination waynel
What is the easist way to check on options, strike price, date ect..
I use etrade but I have never found an easy way to check options or even to buy options with etrade
 
Thanks wayneL - just to confirm, I was speaking theoretically. I'm not going to sell or exercise them just yet.

wayneL said:
Now because you have zero extrinsic value, the delta of the option =1. That means the sahre and the option will move lockstep with each other. So the share price goes to 40c, the option will move to 20c.
Click to expand...

Hmm...so they will always be linked like that?
So even if, say the SP went to $2, it wouldn't be worth exercising the options? When would anyone exercise the options then?

Cheers,
- Febs.
 
vicb said:
Great explaination waynel
What is the easist way to check on options, strike price, date ect..
I use etrade but I have never found an easy way to check options or even to buy options with etrade
Click to expand...
I trade ETO's so don't have that info, but it has been mentioned somewhere, try a search, or perhaps someone knows where that info is?
Febs said:
Hmm...so they will always be linked like that?
Click to expand...
No.

When the share price is nearer the strike price of the option, and depending on factors like volatility and time til expiry, delta may be less than one, so the option will move around less than the underlying in $ terms. A quick rule of thumb is that if the option has extrinsic value, delta will be less than 1. Refer to an option pricing model for more details.

Febs said:
So even if, say the SP went to $2, it wouldn't be worth exercising the options? When would anyone exercise the options then?
.
Click to expand...
There is certainly no benefit in exercising before expiry as you still have 20c less risk...unless you want to capture a dividend. But that does not seem likely with this share.

You would exercise
*at expiry
*and the option is in the money
*and you want to hold the shares
*or you want to capture a dividend

Cheers
 
Revisiting this thread a little confused am I.

Someone bought VREO today for .22c and based on the help from waynel and sails (thanks to both) where they could have bought VRE for .35c (on sell side)

So in fact it seems to me if they exercise the options sometimes in the future they will in fact be paying .42 .... 20c + 22c if I understand how options work.

Now there must be a logical reason why that person was willing to pay in effect 44c when they could have got (presumably) the same thing for 35c at market.

So there is something I am STILL not understanding here .. (be gentle please)

Rob
 

Rob,

The main reason people would by an option like VREO @ 22c with an excise price of 20c instead of buying VRE straight out at 35c is for the extra leverage.
1) They can buy more shares for the same $ amount, for example for a $10,000 outlay they can get 45,454 options but only 28,571 shares.

2) In theory with company options like this, for every cent the heads move in value the options will move roughly the same amount, so therefore you will get a higher percentage return on the same $ movement. E.g 1c of 22c = 4.5% increase but 1c of 35c = 2.85% increase

So with the above examples of a $10,000 outlay. For every 1c price movement with the options it would be a $454.54 gain/loss but with the shares it would be a $285.71 gain/loss. As you can see it also increases your risk as well as your reward.

Also bear in mind that VREO (from my quick look) doesn't expire till June 08 so the buyer in this case might have no intention of exercising the options as they may only be looking for a shorter term trade and are betting on VRE going up shortly.

Hope this helps.
 
Thanks for that nm4s

Something more for me to think about ... its all a matter of percentages I guess and how much VREO appreciates than VRE itself.

I just naturally assumed that the buyer would want to exercise the shares (pretty dumb) of course you can trade the options the same way.

So using your example for the $10,000 outlay ... say VRE goes to $1 for simplicity sake they would be worth $29k roughly for a $19k profit

and the options if converted would cost roughly $19k all up so they would need to trade somewhere around 85c for the same result.(assuming my rough math is correct)

So VRE $1.00 VREO .85c is this a realistic scenario ?

Still a little complicated for me at this early stage.... if I remain in the 3% after my year apprenticeship is over I might dabble in options...
assuming the Bear doesn't get me

Thank you

Rob
 
Rob,

If they do convert the options to shares as per your post, it would cost them roughly $9100 (45,454 x 20c) plus whatever fees it costs. So therefore the total outlay is $19,100 + fees etc.

Remember if you convert your options they become fully paid shares.
So therefore they would now have 45,454 shares that have cost them $19,100, but if VRE were now at $1.00, they would have a holding valued roughly at $45,400, so a profit of about $26,300.
Of course in the above example you pay an extra $9100 dollars for an extra $7000 or so profit (over buying the heads straight up). But remember you have a till June 08 to pay the additional money.

But if they chose not to convert the options and just sold them instead, even at 82c (VRE valued at $1.00) they would make a profit of roughly $27200 (45,454 x 82c - $10,000), so if you could sell them for anything above 80c it would actually be more profitable to sell the options & you don't have to outlay anymore money (but you miss out on any future profit/price increase of VRE).

In regards to the value, if VRE go to $1.00 the options (VREO) should be worth roughly 82c - 85c with an excise price of 20c. But generally the closer it gets to the expiry date the less of a premium the options trade at to the heads.

The above are purely hypothetical examples and it would depend on your trading plan and timeframe for the best method for you, also remember option holders normally miss out on any D/E or special share issues or whatever.

Hope all that makes sense, have just finished training and still a bit groggy.
 
nomore4s said:
Rob,


Hope all that makes sense, have just finished training and still a bit groggy.
Click to expand...

Yes makes lots of sense and more to think about

Learning all the time

Thank you for the effort

PS I don't own any at the moment but am looking to add to my Gold type stocks portfolio

Rob
 
vicb said:
What is the easist way to check on options, strike price, date ect..
I use etrade but I have never found an easy way to check options or even to buy options with etrade
Click to expand...

I find Tradingroom the best to find exercise price and date
You can even check if a company has listed options there as well.

As for fees to convert options, there should not be any except the costs of sending a cheque/money order and postage.
 
Hi Guys,

some great info here... I need to ask once the options expire can I convert them ?

Say I have options that finished on the 30th Sept do I need to convert them before this date or do I have time after this date to convert them.

Thanks guys...
 

Sorry mate.

You needed to convert them before 30 Sept.

If their expiry date is 30 Sept they have expired... evaporated... nonexistant anymore.
 
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