First question - when I look at the options chains, the strike price and the bids/asks never compute to the same profit/loss mark. Say an stock is trading at $30. A put at $31 might cost $1.30, meaning I make a profit buying the put if the price falls to $29.70, right? But a put at $32 might cost only $2.00, meaning now I’m profitable at an even $30. Plus, if I guess wrong and the stock rises to $31.50, I can at least get some money back exercising the $32 option, but not the $31.
So why would I ever buy the $31/1.30 put?
Second question - why are options with longer periods so much more expensive? I figure it’s because I have a longer time to wait until the option is in the money, but doesn’t that imply that a trend in the stock price will reverse itself? That doesn’t seem likely enough to warrant another %50 or so over the shorter expiration.
The questions you’re asking are called “the greeks” by option traders. There is a specific formula called the Black-Scholes formula that shows the relationship between them. I’ll give you a quick answer below, but here’s the link to get started if you want to know more.
Because there’s more time for things to go your way. Right now, Apple is trading at ~500. What are the odds of it getting to 1000 by tomorrow? Extremely low, right? But what are the odds of it getting to 1000 at some point within the next 5 years? Significantly greater. So clearly an option that lasts 5 years must be worth far more than one that lasts only a few days. That’s called the “time value” of the option.
Option traders call the time value “theta” and it is not linear – ie, if you double the amount of time, the price does not double – sometimes it more than doubles and sometimes it less than doubles. See the Black-Scholes equation to tell you exactly what the relationship is.
What if the stock ends up above $32 when the option expires? Then you’ll be better off buying the $31/1.30 put. Yes, you lost money; but you lost less money than you would have lost by buying the $32/2.00 option. So the $31 option has higher risk/reward than the $32 option.
This leads in to the concept option traders call “delta”. Basically, the closer you are to breaking even on the option, the more the option is worth. Again, it is not linear.
Typo: I meant the $31 has a LOWER risk/reward than the $32. So the reason you’d buy the $31 is if you wanted to be more conservative. (And if you wanted, you could be even MORE conservative by buying a $30, $29, $28, $27, etc option. IE – in your example the stock is currently selling at $30, so imagine buying a put option with a strike of $15. It’s very unlikely the stock will fall low enough for you to exercise. But that will be reflected in the price of the option, so you could buy that option for probably only a few cents. Low risk/low reward).
Options trading is usually a lot more complex than just buying a put or a call. Generally people who trade options do so with a particular strategy in mind. For example if you know that a company tends to show a lot of volatility around it’s earnings announcement, you might buy a straddle - both an out of the money put and call that only pays off if the stock moves a lot in one direction or the other.
You can also use options to at least partially cash in gains w/o selling the underlying security. So for example if I have 100 shares of X that is selling at $10 but I’m worried it might drop, I can sell an $11 call option on the stock for some future date. That lets me collect the premium on the call now and compensates me for any potential loss. If the stock rises above $11 and the contract is assigned, my stock gets goes to the contract owner, I get $11/share and keep the premium.
However to sell options you’ll need to be approved by your broker and it’s not something to get into lightly. You can expose yourself to considerable losses if you don’t know what you’re doing.
Assume you have $26 to invest. You would be able to buy 20 of the $31 strike puts or 13 of the $32.00 strike puts. If the price were to fall $25 by expiration, the $31 strike puts would pay $6 per option minus $1.30 for a net profit of $4.70 each; the $32 strike would net $7 - $2, for $5 each.
So,
for the $31 strike, the net profit would be $4.70 * 20 = $94
for the $32 strike, the net profit would be $5.00 * 13 = $78
In this case, the pit that costs $1.30 gives you a better return on investment. Essentially, you have more leverage because of the cheaper initial investment.
But let’s look at the total payouts for a variety of scenarios to understand what would happen further (assuming a $26 investment in each instance and using the same math above, again talking about the underlying price at expiration).
Expire above 32:
both worthless, both lose $26 (the cost of the initial investment)
You should be able to see here that $1.30 is simply more levered and once the stock falls to about 29 or below, the cheaper purchase will start to pay off better. The probability that it will pay off is lower, of course, as it requires a greater movement in the stock price. It’s actually riskier than the $2.00 when measured by risk in trading terms, where risk equals volatility of returns (literally, that’s all risk means when talking about investments).
It is, however, a cheaper potential insurance policy when you start pairing it up with other pieces of a portfolio, which I think may have been what other posters were referring to. But it’s important to make sure that whenever you analyze these things not to compare them 1-to-1, you need to make sure to take into account the difference volume of the product that you can purchase for the same amount of money to see how an equal investment in either would compare in total payoffs.
My chart didn’t format well and I’ve missed the edit window, the first column is the expiration price, the second column is the net payout of 20 of the $31 strike puts, and the third column is the net payout of the #32 strike puts.
And, obviously, in the first example I give in text, 5*13 is 65, not 78. That’s what I get for constantly changing my mind on what example to use.
Well, when you’re talking about American options, you could always sell prior to expiration if you thought a trend were going to reverse itself. But the reality is that stock prices tend to increase over time, so when you’re trading in large volumes (buying 1 or 2 options is speculating, not investing) you don’t worry about stuff like that, you manage your portfolio.
I won’t comment on the rest of the example since there are a host of factors to consider. **Doubled **was quite correct to refer the OP to the Investopedia link on “The Greeks.”
One thing that you got obviously wrong though was the fact that options contracts are sold on whole lots of 100 shares. So in your example, he would need $130 for 1 $31 put contract and $200 for 1 $32 put contract.
Yes, quite right, I just didn’t think the extra 00s would help the reading. The math and outcome remains the same. You would be comparing 2000 of the $31 strike puts to 1300 of the $32 strike puts.