Tag Archives | moneyness vs. profitability

Misconceptions that will not go away

One of my basic jobs as an education blogger is to field questions from investors who don’t quite get how options work and explain situations in terms they can understand. This is something that I believe I do very well and it’s the reason I prefer to work with people who are in the early stages of their trading career.

However, I do occasionally receive the same or similar question from the same reader. That means that I have failed to do my job, or I have encountered someone who simply does not understand. It’s true that options are not for everyone, but I thought that refers to people who decide that the advantages of using options are not sufficient to overcome the required sacrifices.

Mark,

I thought you did an excellent job of explaining writing covered calls. Still, I am so confused now I almost do not know how to phrase my question. I will try.

1. When I bought a call position on an underlying stock, and the stock price exceeds the strike price and the cost of the option, regardless of time remaining, am I in the money?

2.When I want to sell (to close) my call position, what price do I receive? The bid price?

A note: I have been trading stocks only for 4 years and am up 90%. I am now studying these options but am unsure, scared actually of the bid and ask prices fooling me – even when I correctly select a rising stock price level. So maybe my question is: is it possible for a stock to exceed the cost of the call option+ premium and by option expiry still not make money?

Craig

Craig,

There is a cry for help in your questions. I get your frustration. However, I need your cooperation.

If you don’t know that you can sell at the bid price, how do you trade? That is so basic. You have been trading stock for four years? Really? When you sell stock, do you sell at the bid price? Options are no different.

Somehow you missed the boat. Wherever it is that you learned about options, it has failed you. You came away from your education with wrong ideas and essentially ZERO understanding of how options work. Sure, you know that buying call options may lead to profits when the stock rises, but that’s not enough information.

Let’s see if I can help with a brief reply. You are going to be asked to forget what you believe and to believe something different. Can you do that?

To begin, a covered call is an option you sold. Your question concerns an option you bought. That is an entirely different situation.

1) Forget the price of the option. Forget the premium paid. If the stock price exceeds the strike price of a call option, then yes, the option (not you, but the option) is in the money.

The cost is 100% irrelevant. I explained that earlier.

An option is in the money (ITM) when the option has intrinsic value. A call option is ITM when the stock price is higher than the strike price. A put option is ITM when the stock price is below the strike price.

Please note: The option premium (price paid for the option) is not part of the definition. The term ITM is a definition. It compares only two things: stock price and strike price. Option cost is not part of the definition. Profitability is not part of the definition. You are asking about profitability on one hand and ITM on the other. They are NOT the same thing.

It’s very simple: If you can sell your option for more than you paid, you have a profit. This is no different from trading stock. It’s not necessary to add this to that and arrive at a sum. It’s not necessary to add premium to strike price. All you have to do is compare the cost with the proceeds.

2) Yes. You receive the bid price. However, you are not obligated to accept that price. You may try to get a higher price. How do you do that? Just ask.

Enter a LIMIT order to sell, stipulating the LOWEST price that you will accept. Sometimes that limit order is not filled because no one is willing to pay that price. But it does not hurt to ask. Thus, If the market is $4.00 bid and $4.30 ask, you can try to sell at a price above $4. In this scenario, I suggest asking $4.10. Don’t ask $5 and expect to get anyone to pay that.

Set your limit price above the bid price, but less that midway between the bid and ask prices. In my example, that would be $4.15 or less. That’s why I chose $4.10. If no one wants to pay $4.10, after five minutes you can always lower your limit price to $4.00.

3. Why do bid and ask prices scare you? Stocks also have bid and ask prices. Do you know what you are doing when trading stock? If yes, options trade the same way. The products are very different, but each trades on an exchange, each had bid and ask prices. Why do options frighten you but stocks do not?

4. As to your last question. The answer is no, assuming you meant to ask if the stock price exceeds the strike price plus the premium paid for the option. In that scenario you earned a profit (it may be very small).

But you are misguided when it comes to options. You clearly got off on the wrong foot, did not learn anything practical. You seem unable to get rid of misconceptions that hurt becasue they result in your looking at specific situations in a strange manner.

Suggestion

Start all over. Find a different place to learn. Perhaps a different book (try The Rookies Guide to Options), perhaps some free webinars from your broker…Do something different. Pretend you know NOTHING and begin again.

Advice: When you buy an option, there is no reason to hold it to expiration. In fact, that is a very foolish thing to do.

You bought the option when you wanted to buy it. So why would you consider selling at any time OTHER than when YOU want to sell? Why would you hold to expiration and accept that as a randomly chosen selling time? Don’t do it.

Options have time decay. The longer you hold, the more it costs. Thus, sell the option when you no longer want to own it. Sell the option when you believe the stock is no longer moving higher. Sell the option before expiration and you will not lose all of the time value.

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