Determining Option Price. Target Price, Strike Price, Option Premium!

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1 Determining Option Price Target Price, Strike Price, Option Premium!

2 Decide on Strategy Direction, magnitude, risk! Up! Buy Calls! or! Sell Puts! or! Combo! Direction! Down! Buy Puts! or! Sell Calls! or! Combo!

3 Magnitude How big of a move do you expect?!

4 Risk Probability and Amount of Capital!! Is there a high probability of stock moving big in the direction of my call or put?!! How much capital will I put at risk?!! If the option premium has significantly increased due to heavy volume, do I feel it could be a little much to pay for the call or put only?!! Can I get my position for free?!

5 Finding My Price Target Calls! Buying Calls: Option Strike Price + Option Premium < Stock Target Price.! Target stock price = $50, current price = $44, Dec 45 call price = $1.50! OK! Target stock price = $50, current price = $44, Dec 45 call price = $5.05! X No!

6 Finding My Price Target Puts! Buying Puts: Option Strike Price + Option Premium > Stock Target Price.! Target stock price = $40, current price = $48, Dec 45 put price = $1.50 (put strike price ($45) - option premium ($1.50) = $43.50)!! OK! Target stock price = $40, current price = $46, Dec 45 put price = $5.05 (put strike price ($45) - option premium ($5.05) = $39.95)! X No!

7 Room for Error I like to leave room for error, and a decent profit margin, so if there is not a decent amount of room between my target price and (strike price + option premium) then I will not do the trade.! The only way I will do the trade in this situation is if I use a combination of options to significantly lower my cost where I may get the trade on for free or even get a credit for it. This would add a bit of risk though too, so I have to weigh that and be comfortable with it.!

8 Examples Scenario 1! I think XYZ is a great price at $50, and they are trading at $53. I also believe they should get to $65 soon. The 55 call is priced at $2, the 50 call is priced at $5, and the 50 put is priced at $2.! In this case I would buy the 55 call and sell the 50 put, because I could get the position for free, and the worst that could happen is I get the stock I like at the price I like. If the stock goes to 65 like I think, my profit would be anything above $55.!

9 Examples Scenario 2! I think XYZ is a great price at $50, and they are trading at $50. I also believe they should get to $75 this year, but I don t know exactly when. The Jan (leap) 55 call is at $10, the 50 call is at $13, and the 35 call is at $15.10.! In this case I would buy the 35 (deep in the money) call, because it is basically the same as buying the stock here but only risking and tying up half the capital. This gives me time to be patient and wait. If the stock is still not at my target price upon expiration I can exercise my option to buy the stock for $35 and sell covered calls while I wait.!

10 Examples Scenario 3! I think XYZ could make a big jump after they get approval for their new drug coming out later this year. The stock is at $5, and I believe the stock could double. The January 5 calls are at $1.15 and the 7 calls are at $0.15.! In this case I would buy the Jan 7 calls for $0.15 because if they get the approval I expect a huge move, but if they don t they probably won t be much higher than $5. Since this is a more speculative play based on approval for a new drug, I want to limit my risk by paying a smaller premium, because if I am wrong I am going to lose money either way. And I would rather lose a little than a lot. But if I am right I m going to make a lot of money either way.!

11 General Rules If you expect a big move and the option premium is not high then you probably don t want to hedge your position (using spreads or combos). You can just buy a call or put outright.! If you expect a defined move (ex. within $20-$25), and option premiums are high, you may want to hedge by using a spread or some other combo.! If you have no idea, or premiums are too high or require too much risk to hedge, just walk away.! When selling options, make sure you get enough premium to make it worth it. If you get $0.50 for a covered call that expires in 30 days on a stock that could easily move $5 you will be disappointed if you get called out for only $0.50 more. If you are selling puts, make sure it gives you a cushion or good margin for error. I usually like to get at least $1 for options I am selling. (You also have to consider any fees or commissions for the trade.)!

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