Show notes
Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to actually look at another simple Apple call option example. We actually did this a couple of podcast back. I thought it was good, we could look at another one again here today and look at call options in Apple. Apple is a really popular stock. Everyone loves call options. We'll look at it in two different cases. We'll look at a simple selling of a call option and then we'll look at option buying examples. And again, the idea behind doing this is just so you get at least some frame of reference for how this might work in the real world. We talk a lot in theory here about how option pricing works and how option contracts work, but sometimes it's really important just to kind of get a real world example of what's going on and what we could potentially do with an option contract. Remember that options are meant to be there to let you choose how you want your risk payoff diagram to ultimately look like. Option contracts and the entire option pricing chain is there and open at your discretion to choose how much risk you're willing to take, how much or how high of a probability of success you want and how much premium you want to collect or how much you want to pay out in order to exchange that risk in the market. It's really cool. As we go through this, you'll kind of see how that works out with different strike prices and different option premiums.
Right now that I'm doing this, Apple is still trading let's call it around $200 because it makes it pretty simple. It's actually trading a little bit lower than that, but let's call it around $200 that Apple is currently trading at today. With Apple trading at $200, again, if we're looking at call options and we'll first look at option buying, so if we were just super, super bullish on Apple, we loved everything about Apple and we thought it was going to go up to the moon and we want to buy some call options, let's say we buy options that are about 40 days out from expiration and we want to buy something that is cheap because that's what people usually like to do with option buying. They like to buy something cheap, but they don't want to buy something like a lottery ticket. Something really, really far out that's only a couple of dollars, well, they realize that it's probably not going to hit that strike price, so it's probably like wasting money on a lottery ticket. Maybe we go out and we buy something around $220. Seems realistic, seems potentially… I'm just like obviously being very subjective here, but this is what people do. They say, "Oh, $220. That probably seems about realistic. Apple could go up another $20 easily in the next month and a half because it's a $200 stock and it's a good company and I like all the products, so of course, Apple could go up $200 in the next two months."
If we buy the 220 call options, those are around a 15 Delta. It's actually about a 12.5 Delta, but let's call it about a 15 Delta. You have about a 15% chance on the better end of actually making money on this option contract, but that's only to get the stock to that strike price of 220. You still had to pay money to get into this contract and in this case right now, that option contract is trading for about $.95. $95 would allow you to get into this contract which again, this is really in all honesty, this is where people I think a lot fail with initial options trading, is they see that it's $95 and they don't think that's a lot of money, like they think, "Oh, it's a drop in the bucket. It's about $100, good trade. Apple could go up. I could make so much money." And that's like this quickest sand trap basically for new traders. But they see that it's $95 in this case, so our blended breakeven is right about 221, so really, Apple has to get not only to 220 which there's about a 15% chance that that happens, but it's got to get to 221 before we start breaking even. Maybe 12%, 13% chance that it actually gets to 221, somewhere in that range by the time of expiration. Now, the tradeoff here is you don't risk a lot of money. If Apple never gets up there, you didn't risk anything more than say $100 with commissions potentially to get into this. It wasn't a lot of money out of your pocket, but you have an insanely low probability of success, right? You have an extremely low probability of success. It's more likely than not long-term that this thing is going to bankrupt you slowly with a thousand cuts, right? Like this is a death by a thousand cuts for option buyers. Yeah, you might hit one or two here and there, but over time, it's just going to erode the value of your account.
Let's say you want to do something different on the option buying side. You want to go a little bit further out because you just want a really crazy lottery ticket and so, you go out to the 235s. You think to yourself, "Okay, look. At this point, I just want something insanely cheap because I'm willing to risk and gamble some money." And some people are, right? I'm not that person, but some people are gamblers and they just don't call themselves gamblers as traders, but they are. And so, they go out to the 235s. Now, the 235s are only $20, so $20, pretty much anyone can spend $20 and not blink an eye at it. But this is what I talk about all the time about watching kind of your dollars and watching your cents, so that they grow and start to mature, kind of babysitting these $20 bills and $100 bills. If you just blow this $20 bill on this, sure, it might work out here and there, but long-term, it's a negative expected return as an option buyer. If they go out to the 235s, they spend $20, this has a Delta of .02 which means that there's a 98% chance that you lose your entire $20. You could pretty much attribute this to mostly a lottery ticket. Now, if you want to do this, do it. That's fine. Just call a spade a spade. You know you're gambling. You know this is a huge potential risk and it's not likely to make money.
This is two different ways that you could trade those call options if you were on the long side. Now, obviously if you're on the short side, the same thing would work just in reverse. In the case of selling the 220 options, if you sell the 220 options as a call option writer, then you collect a nice $100 paycheck, but you have risk in case the stock does go above 220 which there's a 15% chance that that happens. You don't have a 100% chance of success, but you're compensated for the fact that you have a pretty good probability of success and you're going to get some money in case you're right. If you went out even further as a call option seller, yeah, you can probably pick up some really cheap and easy money, but in that case, you better have a lot of cash still left in the bank because what if that 2% scenario happened where Apple just exploded higher and you lost way more than the $20 you're collecting in premium? I think you have to understand that it's all relative. Risk and pricing and reward here is all relative and it's pretty fairly distributed. It's almost perfectly priced for what the expectation is for the market. Now, the expectation of reality might not match up once we get to options expiration, but right now, the market is pricing in pretty fair in expected growth for each of these different contracts respectively.
The end result is what do you do? You can choose to do whatever you want. There's no saying that you have to do one versus the other. You got to be an option seller versus buyer. We put out all the research that we do here on Option Alpha. We talk about where the edge is. You can look up other resources, but in our opinion, it's obviously more profitable and the research shows and the data shows it's more profitable to be an option seller, but you can ultimately choose to do what you want to do. Today, I just want to walk through an example, so you have some more realistic numbers to kind of work with than basically just some theory and charts of just general option pricing. Hopefully this helped out. As always, if you have any questions, let us know and until next time, happy trading.
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