Today we’ll talk about what the option chain can tell us about whether trading a particular option might be too costly, in the sense that the “markup” on it is too high.
We know that the buyers of options acquire rights to purchase or to sell an underlying asset (which I’ll call “the stock”) on or before a certain date, and at a certain price. At any given moment, a single stock may have hundreds or even thousands of separate option contracts available. For example, today Apple stock closed at $645.74. We could buy options on the stock of Apple that expire at any of ten separate dates in the future, from 2 days to 821 days out. The strike price of available options ranges from $195 per share to $1040. The options themselves range in price from one cent per share to over $450 per share. Altogether, approximately 3,000 distinct option contracts are available on Apple alone.
Although many of these 3,000 distinct contracts have never sold a single lot, there are posted prices (bid and ask) for every one of them. Whose prices are these?
The answer is that some of these bids and offers are orders placed by retail traders like us; some of them are orders from money managers and other institutions; but the vast majority are prices posted by options market makers. The market makers are option dealers. Their business is literally to buy options wholesale and sell them retail. Their markup or profit margin is the difference between the Bid and the Ask.
Notice in Figure 1 that at this moment the Nov ’12 Calls at the $640 strike have a Bid of $27.50 and an Ask of $27.70. These quotes are per share. A single one of these contracts, which involves… Continue Reading
